Chapter 11
Working Group Proposal #1: Absolute Priority and Exclusivity
The chapter 11 Working Group makes all of its initial proposals in the context of relatively
larger cases, not single-asset or small cases. This Working Group or the Working Group on Small
Business, Partnerships and Single Asset Real Estate may revisit the issues addressed here to
consider whether the same recommendations are appropriate in those circumstances.
According to the rule of absolute priority, which is part of the requirement that chapter 11
cramdown plans be "fair and equitable," a court will not confirm a non-consensual
plan that pays anything to a lower priority class (e.g., equity) if superior classes (e.g., creditors)
are not paid in full. [ FN: 11 U.S.C.
§1129(b).] Practically speaking, this means that pre-petition equity
holders do not have the right to participate in a plan of reorganization over the objections of
unpaid, or partially unpaid, classes of senior creditors. Some courts have held that pre-petition
equity holders may, under highly circumscribed circumstances, participate in the plan
without violating the absolute priority rule, even if senior creditors are not paid in full, by
essentially purchasing new interests in the reorganized business. This participation based on
additional contributions to the business commonly is known as the "new value
exception" to the rule of absolute priority. The new value exception was a reasonably
well-established principle under the Bankruptcy Act, but courts and commentators have debated
its continuing vitality under the Bankruptcy Code of 1978.
The question of old equity participation has generated a substantial body of case law,
[ FN: A recent survey of the case law has
indicated that one hundred and one published lower court decisions (that have not been reversed
directly or vacated) have discussed the viability of the new value exception since the Supreme
Court ’s decision in Norwest Bank Worthington v. Ahlers , 108 S. Ct. 963 (1988)
(expressly reserving question of whether new value exception survived enactment of 1978 Code).
J. Ronald Trost, Joel G. Samuels, & Kevin T. Lantry, "Survey of the New Value Exception
to the Absolute Priority Rule and the Preliminary Problem of Classification, " (July 1, 1996),
printed in materials corresponding to New York University School of Law 22nd Annual
Workshop on Bankruptcy and Business Organizations, 1273 (August 27-29, 1996). Of these
decisions, seventy-four "have expressly or implicitly held that the new value exception is viable
under the Code, 11 have held that it is not, and 16 have regarded the issue as an open question. "
Id.] from which significant problems have emerged. Courts expend
a tremendous amount of time and effort on the threshold question of whether the new value
exception survived enactment of the 1978 Code. The litigation is expensive and delays progress in
the plan negotiation process. The mere mention of the question incites courts and commentators
to embark on an analysis ofsemantics, history, and statutory interpretation. Even when courts
express doubts that the exception remains viable, they often march through full analyses to prove
that the exception would not apply in any event. In addition, the determination of whether the
new value exception applies is extremely fact-specific and depends heavily on the courts’
valuation theories and techniques. As a result, the same new value plans that have been confirmed
in some courts may have not even made it to the confirmation hearing stage in other courts.
Likewise, plans that could bring enhanced value to creditors and save jobs may have been
dismissed out of hand on questionable economic grounds.
This legal uncertainty creates a precarious environment for plan negotiations and business
reorganizations of large businesses that seek to avoid the expense and delay of judicial valuation
proceedings entailed in non-consensual plan confirmations. Pre-petition equity holders often can
provide a valuable source of capital that may be necessary to the effective reorganization of a
viable, but currently insolvent, business. Whether a debtor is entitled to count on this equity
contribution can have a significant impact on the likelihood of successful reorganization. Some
commentators believe that it is the creditors, as residual owners of the insolvent business, who
should decide whether the business will have access to this capital. [ FN: See Douglas G. Baird, "The Uneasy Case for
Corporate Reorganizations, " 15 J. Leg. Stud. 127 (1986). See also Richard L. Epling, "The
New Value Exception: Is There a Practical Workable Solution? " 8 Bankr. Dev. J. 335 (1991)
(listing this as competing consideration to application of new value
exception).] Whether creditors can preclude pre-petition equity
participation ultimately depends on the strength of their legal positions.
At the same time, courts, commentators, and creditors are concerned that pre-petition equity
holders, whether or not they are working in concert with management, might trade on their
increased knowledge and insider status and will pay a below-market price for the assets of the
business. While courts do the best they can to determine the relative equivalence between the
contribution offered and the interest received, [
FN: See Consolidated Rock Products Co. v. Du Bois , 312 U.S. 510 (1941) (finding
capitalization of future earnings to be appropriate method for determining value of equity
interests).] judicial valuation proceedings have significant shortcomings and
leave some observers wary. [ FN: See,
e.g. , Chaim Fortgang and Thomas Moers Mayer, "Valuation in Bankruptcy, " 32
U.C.L.A. L. Rev. 1061, 1125 (1985).] If the bids of pre-petition equity
were exposed to the marketplace, undervaluation concerns could be alleviated without thwarting
potentially successful reorganizations.
The exclusivity period provides a powerful tool to a chapter 11 debtor: the exclusive right to
propose the terms and conditions of its reorganization. [ FN: "Except as otherwise provided in this section,
only the debtor may file a plan until after 120 days after the date of the order for relief under this
chapter. " 11 U.S.C. §1121(b). "On request of a party in interest made within the
respective periods specified in subsections (b) and (c) of this section and after notice and a
hearing, the court may for cause reduce or increase the 120-day period or the 180-day period
referred to in this section. " Id. §1121(d).] Currently
under the BankruptcyCode, the rules and time restrictions that govern exclusivity apply with equal
force to all chapter 11 plans, whether or not the plan is consensual and whether or not the plan
proposes continuing participation by the pre-petition equity holders. Currently under 11 U.S.C.
§ 1121(d), a court can shorten or terminate the exclusivity period for cause. Parties have
observed, however, that courts commonly extend the exclusivity period in large chapter 11 cases
as a matter of course, much to the frustration of some creditors.
The Recommendation
The chapter 11 Working Group recommends that the Commission consider the following:
11 U.S.C. § 1129(b)(2)(B) should be amended to provide that the court
may find a plan to be fair and equitable that provides for members of a junior class of
claims or interests to purchase new interests in the reorganized debtor.
11 U.S.C. § 1121 should be amended to provide that on the request of a
party in interest, the court will terminate exclusivity if a debtor in possession moves to
confirm a non-consensual plan that provides for the participation of a holder of a junior
claim or interest but does not satisfy the condition set forth in section
1129(b)(2)(B)(i). [ FN: Fed. R. Bankr.
P. 3016(a), which governs the time for filing a plan in a chapter 11 case, would have to be
amended to reflect the proposed modification.]
This proposal would end the threshold debate. If Congress made such changes, pre-petition
equity holders would not be foreclosed from participation. The resulting certainty in the law
should increase the likelihood and efficacy of out-of-court settlements. If a debtor ultimately
attempted to cram down a plan that involved debt forgiveness and participation of old equity, a
party in interest could request the termination of exclusivity. The court would grant the motion as
of right. Once exclusivity had been terminated, any party eligible under section 1121 to propose a
plan would be able to do so. This change is intended to protect dissenting creditors by allowing
market forces to provide a check on equity participation.
This proposal contemplates that the central principle of the absolute priority rule remain in
full force and effect. The plan proponent would have to demonstrate that equity would purchase a
new interest and not retain its pre-petition interest under the tests already in place in the courts.
Moreover, because pre-petition equity would not have the exclusive right to bid, this proposal
should alleviate the concerns of those who believe that a preemptive right to participate in theplan
is, itself, impermissibly-retained property. [ FN:
See , e.g. , Travelers Ins. Co. v. Bryson Properties, XVIII (In re Bryson
Properties, XVIII) , 961 F.2d 496 (4th Cir.), cert. denied , 506 U.S. 866 (1992); In re
BMW Group I , 168 B.R. 731, 735 (Bankr. W.D. Okla. 1994); In re Ropt Ltd. Partnership , 152
B.R. 406, 412 (Bankr. D. Mass. 1993). But see Bonner Mall Partnership v. U.S. Bancorp
Mortgage Co. (In re Bonner Mall Partnership) , 2 F.3d 899 (9th Cir. 1993) (exclusive
option to bid not retained property), cert. granted , 114 S. Ct. 681, motion to vacate denied
and dismissed as moot , 115 S. Ct. 386 (1994).] The bidding process
will assist the judge in determining whether pre-petition equity holders truly are offering a fresh
contribution of assets that is equivalent to the interest they expect to receive.
Background
Absolute Priority under the Bankruptcy Act
To be confirmed under chapter X and its predecessor, section 77B, of the 1898 Bankruptcy
Act, all plans had to be subjected to court determination that they were "fair and
equitable" to creditors. [ FN: 11
U.S.C. §621(2) (repealed 1978). Cf. 11 U.S.C. §1129(b), which imposes the fair and
equitable requirement on non-consensual plans only.] According to the
United States Supreme Court decision Northern Pacific Railway Co. v. Boyd,
a "fair and equitable" plan paid proper heed to the priority of various creditors and
equity holders in accordance with contract principles. The court perceived a debtor entity as
"a trust fund charged primarily with the payment of corporate liabilities. Any device,
whether by private contract or judicial sale under consent decree, whereby stockholders were
preferred before the creditors, was invalid." [
FN: Northern Pacific Ry. v. Boyd , 228 U.S. 482, 504 (1913) (striking down railroad
reorganization plan); Louisville Trust Co. v. Louisville, New Albany & Chicago Ry. Co. ,
174 U.S. 674, 684 (1899) ( "any arrangement of the parties by which the subordinate rights and
interests of the stockholders are attempted to be secured at the expense of the prior rights of
either class of creditors comes within judicial denunciation "). See also Edward S. Adams,
"Toward a New Conceptualization of the Absolute Priority Rule and its New Value Exception, "
1993 Det. C.L. Rev. 1445, 1447 (rule reflects fundamental relationship between equity and
creditors that underlies law of business associations).] Creditors were
entitled to the going concern value of the business and parties were not permitted to bargain away
the fair and equitable requirement.
Yet, the early cases recognized that the fixed principle of absolute priority announced in
Boyd was not quite absolute. As the Supreme Court recognized in Kansas City
Terminal Ry. Co. v. Central Union Trust Co. of New York, another railroad
reorganization, former stockholders should be able to provide new money for the reorganization
in some instances, so long as there were sufficient protections for creditors:
[T]o the extent of their debts creditors are entitled to priority over stockholders against all
property of an insolvent corporation. But it does not follow that in every reorganization the
securities offered to general creditors must be superior in rank or grade to any which stockholders
may obtain. It is not impossible to accordto the creditor his superior rights in other ways.
Generally, additional funds will be essential to the success of the undertaking, and it may be
impossible to obtain them, unless stockholders are permitted to contribute and retain an interest
sufficiently valuable to move them. In such or similar cases the chancellor may exercise an
informed discretion concerning the practical adjustment of the several rights. [ FN: Kansas City Terminal Ry. Co. v. Central
Union Trust Co. , 271 U.S. 445, 455 (1926).]
Due to the inadequate record before the Supreme Court in that case, the Supreme Court
declined to rule on whether the plan was confirmable.
Building on this concept, the Supreme Court uttered what became the formulation of the
so-called new value exception in Case v. Los Angeles Lumber Products. [ FN: Case v. Los Angeles Lumber Products , 308
U.S. 106 (1939).] The debtor was a holding company for the capital stock
of six subsidiaries, of which only one had substantial value. The insolvent debtor’s plan
gave former Class A shareholders 23% of the assets and voting power. In exchange, the
shareholders offered intangible benefits stemming from their financial standing, community
influence, and continuity of management. The Supreme Court held this was not a fair and
equitable plan. [ FN: Such contributions
"have no place in the asset column of the balance sheet of the new company. They reflect merely
vague hopes or possibilities . . . [R]igorous standards of the absolute or full priority doctrine of
the Boyd case will not permit valueless junior interests to perpetuate their position in an
enterprise on such ephemeral grounds. " Id. , at 123.] Yet, the
Supreme Court acknowledged that "it is, of course, clear that there are circumstances under
which stockholders may participate in a plan of reorganization of an insolvent debtor:" the
Court hypothesized that a plan might be confirmed if "necessity exists and the old
stockholders make a fresh contribution and receive an interest that is reasonably
equivalent to their contribution," if such contribution was in money or
money’s worth. [ FN:
Id. , at 121, 122 (emphasis added).]
Los Angeles Lumber was decided under former section 77B of the Bankruptcy Act
and ultimately applied to the successor chapter, chapter X. [ FN: chapter X not only included a fair and
equitable requirement, but its consensual plans required the support of all creditors, not just the
majority of each class of creditors. As a result, the dissenting creditor ’s leverage was
higher than it is under the current chapter 11, which allows the majority to bind dissenting
minorities by class voting. Some commentators have opined that a new value exception, which
was crucial to the confirmation of cases when dissenting creditors held such heightened leverage,
is less necessary under the 1978 Code. Clearly, the leverage of each party has shifted in a number
of ways since 1978, but the persistence of other issues surrounding participation by old equity,
such as valuation and the survival of marginal entities, keep the new value exception
relevant.] chapter XI, however, imposed no express or implied absolute
priority rule; creditors were entitled only to liquidation value. [ FN: H.R. Rep. No. 595, 95th Cong., 1st Sess. 412
(1977), reprinted in Collier on Bankruptcy, Appendix 2, at 222 (15th ed. 1996). This is an
important historical fact to keep in mind, particularly when considering the best way to deal with
smaller reorganization cases, for which chapter XI was designed.]
The Bankruptcy Code of 1978
The 1978 Bankruptcy Code codified the fair and equitable requirement to include the
Boyd "fixed principle" of absolute priority and made it applicable to
non-consensual chapter 11 plans. [ FN: For
a discussion of whether this was prudent and cost-effective, see Douglas G. Baird and Thomas
H. Jackson, "Bargaining After the Fall and the Contours of the Absolute Priority Rule, " 55 U.
Chi. L. Rev. 738, 747 (1988).] This enabled and indeed was designed to
encourage parties to bargain for consensual plans that need not be subject to judicial "fair
and equitable" scrutiny. [ FN: Some
commentators have argued that Congress intended to promote settlements that did not comport
with the absolute priority rule to protect equity holders from domination by powerful creditors.
See Lynn M. LoPucki & William C. Whitford, "Bargaining Over Equity ’s Share in
the Bankruptcy Reorganization of Large, Publicly Held Companies, " 139 U. Pa. L. Rev. 125, 133
(1990).] If the parties failed to reach consensus and the debtor sought
confirmation over objections of classes of impaired creditors, at that point the court would assess
whether the plan was fair and equitable. Under section 1129(b)(2)(B), a "fair and
equitable" plan would have to satisfy fully the claims of senior classes of unsecured
creditors before junior classes could receive or retain any property "on account of"
their prior ownership interests. [ FN: 11
U.S.C. §1129(b)(1) provides: Notwithstanding section 510(a) of this title, if all of the
applicable requirements of subsection (a) of this section other than paragraph (8) are met with
respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan
notwithstanding the requirements of such paragraph if the plan does not discriminate unfairly, and
is fair and equitable, with respect to each class of claims or interests that is impaired under, and
has not accepted, the plan. (2) For the purpose of this subsection, the condition that a plan be fair
and equitable with respect to a class includes the following requirements: . . . . (B) With respect
to a class of unsecured claims - - (i) the plan provides that each holder of a claim of such class
receive or retain on account of such claim property of a value, as of the effective date of the plan,
equal to the allowed amount of such claim; or (ii) the holder of any claim or interest that is
junior to the claims of such class will not receive or retain under the plan on account of such
junior claim or interest any property.]
Congress codified the absolute priority rule without any explicit authorization -- or
prohibition -- of old equity participation in non-consensual plans. Courts have found the
legislative history to be inconclusive. [ FN:
See , e.g. , In re Bryson Properties, XVIII , 961 F.2d 496, cert. denied , 506 U.S.
866 (1992); Penn Mutual Life Ins. Co. v. Woodscape Ltd. Partnership (In re Woodscape
Ltd. Partnership) , 134 B.R. 165, 170 (Bankr. D. Md. 1991).] In its
recommendations for legislative change that preceded the enactment of the 1978 Code, the 1973
Commission on the Bankruptcy Laws of the United States proposed an explicit corollary to the
absolute priority rule that would have allowed courts to consider the value of less tangible and
prospective contributions, such as the benefits of continuity of management. [ FN: Report of the Commission on Bankruptcy
Laws, H.R. Doc. No. 137, part I, 258-259, 93rd Cong., lst Sess. (1973). The National
Conference of Bankruptcy Judges made the same suggestion. See Kenneth N. Klee, "Cramdown
II, " 64 Am. Bankr. L.J. 229 (1990), citing S. 235, 94th Cong., 1st Sess. 209 (1973) and H.R.
32, 94th Cong., 1st Sess. 223 (1975).] Congress did not put the 1973
Commission’s liberalized formulation, or the traditional Los Angeles Lumber
formulation, in the Code.
Case Law under the Bankruptcy Code
Barring instruction to the contrary, many courts presumed that the pre-Code parameters of
"fair and equitable," including the new value exception, remained in effect. [ FN: See , e.g. , Teamsters National
Freight Industry Negotiating Comm. v. U.S. Truck Co. (In re U.S. Truck Co.) , 800 F.2d
581 (6th Cir. 1986); In re Potter Material Service Inc. , 781 F.2d 99 (7th Cir. 1986);
In re Sawmill Hydraulics Inc. , 72 B.R. 454, 456 (Bankr. C.D. Ill. 1987); Buffalo Savings
Bank v. Marston Enterprises Inc. (In re Marston Enterprise Inc.) , 13 B.R. 514, 518
(Bankr. E.D.N.Y. 1981); In re Eaton Hose and Fitting Co. , 73 B.R. 139 (Bankr. S.D.
Ohio 1987); In re Roberts Rocky Mountain Equip. Co. , 76 B.R. 784 (Bankr. D. Montana
1987); In re Landau Boat Company , 13 B.R. 788 (Bankr. W.D. Miss. 1981). But see
In re Pine Lake Village Apt. Co., 19 B.R. 819 (Bankr. S.D.N.Y. 1982) (silent on new
value exception when finding that equity participation violated absolute priority
rule).] This presumption was challenged by the Supreme Court’s
decision in Norwest Bank Worthington v. Ahlers, which contained a footnote that
expressly reserved the question of whether the new value exception survived the enactment of the
1978 Code. [ FN: "[O]ur decision today
should not be taken as any comment on the continuing vitality of the Los Angeles Lumber
exception--a question which has divided the lower courts since passage of the Code in 1978. . . .
Rather, we simply conclude that even if an "infusion-of-'money-or money's-worth'" exception to
the absolute priority rule has survived the enactment of Sec. 1129(b), respondents' proposed
contribution to the reorganization plan is inadequate to gain the benefit of this exception. "
Norwest Bank Worthington v. Ahlers 485 U.S. 197, 203, n. 3 (1988).]
The Court of Appeals for the 8th Circuit had upheld
confirmation of a plan allowing family farm owners to retain their equity interest in exchange for
future contributions of "labor, experience, and expertise" in the farm enterprise. In
reversing the 8th Circuit decision, the Supreme Court
would go only so far as to say that apledge of future services would not have qualified in any
event, [ FN: Id. , at 206. The
Supreme Court found this pledge of future services to be no more legitimate a contribution than
the Los Angeles Lumber shareholders ’ pledge of "financial standing, influence, and
continuity of management. " "Unlike ‘money or money's worth, ’ a promise of future
services cannot be exchanged in any market for something of value to the creditors today. In fact,
no decision of this Court or any Court of Appeals, other than the decision below, has ever found a
promise to contribute future labor, management, or expertise sufficient to qualify for the Los
Angeles Lumber exception to the absolute priority rule. " Id. at 204. The Court in
Ahlers also rejected a "no value" theory of new value and reaffirmed the Northern Pacific R. Co.
v. Boyd test: whether value is "present or prospective, for dividends or only for purposes of
control "a retained equity interest is a property interest to which the creditors are entitled before
the stockholders can retain it for any purpose whatever." Id. , at
208.] and stated in no uncertain terms that it was not deciding whether the
new value exception survived enactment of the 1978 Code. Thus, the continuing existence of the
new value exception remained an open question. [
FN: See John D. Ayer, "Rethinking Absolute Priority After Ahlers , " 87 Mich. L.
Rev. 963 (1989) (tracing history of supposed exception and arguing that exception was not
justified); Kenneth N. Klee, "Cram Down II, " 64 Am. Bankr. L. J. 229 (1990) (reporting on split
in courts and among academics on the survival of the new value exception in light of Ahlers ); but
see Charles R. Sternbach, "Absolute Priority and the New Value Exception: A Practitioner
’s Primer, " 99 Com. L. J. 176 (1994) (legislative and historical basis for new value
doctrine less relevant to practitioners than practical and equitable considerations that emerge in
chapter 11 proceedings).]
In the spirit of Ahlers, many courts have refused to take a firm position on whether
the new value exception remains in effect if they can decide cases on other grounds, i.e.,
that the plans would not have satisfied the new value requirements in any event. In many cases,
quite frequently in dicta, courts have stated or implied that pre-petition equity holders are not
foreclosed per se from participating in the cramdown plans of insolvent debtors. Nothing
in the Code specifically prohibits old equity from participating in the reorganized business, so long
as their post-reorganization interests are not "on account of" the pre-petition
interests. Interests purchased for new value, by this analysis, involve no "exception"
because they violate no rule. To require a new value contribution for any equity participation --
new equity holders or old -- is simply the corollary to the absolute priority rule. Thus, to some
courts, the rule of absolute priority rule itself permits old equity to exchange fresh capital for a
new equity investment that isnot "on account of" its prior interest. [ FN: In re Bonner Mall Partnership , 2 F.3d
899, 909 (9th Cir. 1993), cert. granted , 114 S. Ct. 681, motion to vacate denied and
dismissed as moot , 115 S. Ct. 386 (1994); In re Snyder , 99 B.R. 885, 888 (Bankr. C.
D. Ill 1989), aff ’d , 967 F.2d 1126 (7th Cir. 1992); In re SM 104, Ltd. , 160 B.R.
202, 225 (Bankr. S.D. Fla. 1993) ($200,000 infusion of money was necessary and substantial and
constituted new value); In re Montgomery Court Apartments of Ingham County, Ltd. ,
141 B.R. 324, 343, 345 (Bankr. S.D. Ohio 1992) (true new value contribution "simply does not
violate absolute priority rule "); In re Creekside Landing, Ltd. , 140 B.R. 713, 717
(Bankr. M.D. Tenn. 1992) ( "exclusion, " not "exception "); In re Woodscape Ltd.
Partnership , 134 B.R. 165 (Bankr. D. Md. 1991); Phoenix Mut. Life Ins. Co. v. Greystone III
Joint Venture (In re Greystone III Joint Venture) , 102 B.R. 560, 574 (Bankr. W.D. Tex.)
(new value is natural extension of absolute priority rule), aff ’d , 127 B.R. 138 (W.D. Tex.
1989) (old equity need not be exclusive source of funding to trigger new value exception), rev
’d on other grounds , 995 F.2d 1274 (5th Cir. 1991) (new value exception discussion
vacated on reconsideration), cert. denied , 113 S. Ct. 72 (1992). See also In re
Trevarrow Lanes Inc. , 183 B.R. 475, 493 (Bankr. E.D. Mich. 1995) ( " Los Angeles Lumber
was neither rejected nor blessed by Congress: rather, the Code leaves it to the courts to decide
whether the "fair and equitable " objective is subserved by the Los Angeles Lumber condition
that the contribution be essential, just as would be true with respect to any other requirements not
specifically set forth in §1129(b)(2) ").] This notion has considerable
support among commentators as well. [ FN:
See , e.g. , Bruce A. Markell, "Owners, Auctions and Absolute Priority in Bankruptcy
Reorganizations, " 44 Stan. L. Rev. 69 (1991) (new value is rough formulation of absolute
priority); Anthony L. Miscioscia, Jr., "The Bankruptcy Code and the New Value Doctrine: An
Examination into History, Illusions, and the Need for Competitive Bidding, " 79 Va. L. Rev. 917
(1993); Elizabeth Warren, "A Theory of Absolute Priority, " 1991 Ann. Surv. of Am. Law 9;
Raymond T. Nimmer, "Negotiating Bankruptcy Reorganization Plans: Absolute Priority and New
Value Contributions, " 36 Emory L. J. 1009 (1987); but see David A. Skeel, "The Uncertain
State of an Unstated Rule: Bankruptcy ’s Contribution Rule Doctrine after Ahlers , 63 Am.
Bankr. L. J. 221 (1989) (absolute priority and new value represent competing goals: protection of
creditors ’ rights and need for successful reorganization).]
Others have concluded that nothing in the Code or legislative history indicate any intent to
modify many decades of judicial construction of the absolute priority rule, and therefore the
"new value exception" has not been abrogated. [ FN: See , e.g. , In re Snyder , 976
F.2d 1126, 1129 (7th Cir. 1992); Anderson v. Farm Credit Bank of St. Paul (In re
Anderson) , 913 F.2d 530, 532-533 (8th Cir. 1990); In re Green , 98 B.R. 981 (Bankr.
9th Cir. 1989) (reversing confirmation of individual debtor whose "new value " was promise to
prosecute $4 million damage claim for the right to keep half of amount collected); Coones v.
Mutual Life Ins. Co. (In re Coones) , 168 B.R. 247 (D. Wyo. 1994) (new value exception
is viable until 10th Circuit or Supreme Court says
otherwise); Matter of Homestead Partners, Ltd. , 197 B.R. 706 (Bankr. N.D. Ga. 1996) (new
value exception survived enactment of 1978 Code, but court must ensure adequate competitive
market); In re Haas , 195 B.R. 933 (Bankr. S.D. Ala. 1996) (presuming validity of new
value exception); In re S.A.B.T.C. Townhouse Ass ’n , 152 B.R. 1005 (Bankr.
M.D. Fla. 1993); In re Montgomery Court Apartments of Ingham County, Ltd. , 141 B.R.
324, 343 (Bankr. S.D. Ohio 1992); In re Sovereign Group 1985-27 Ltd. , 142 B.R. 702
(E.D. Pa. 1992); In re Triple R. Holdings, L.P. , 134 B.R. 382, 389 (Bankr. N.D. Cal.
1991) (partial codification of absolute priority rule not intended to eliminate other aspects); In
re Pullman Constr. Indus. Inc. , 107 B.R. 909 (Bankr. N.D. Ill. 1989); In re Yasparro
, 100 B.R. 91, 99 (Bankr. M.D. Fla. 1989). See also Ralph A. Peeples, "Staying In: chapter 11,
Close Corporations and the Absolute Priority Rule, " 63 Am. Bankr. L. J. 65, 75
(1989).] Some believe that Congress sought to minimize unnecessary
statutory complexity and therefore avoided the codification of every nuance of pre-Code
"fair and equitable" case law development on the assumption that they would remain
ineffect. [ FN: See , e.g. , In
re Triple R. Holdings, L.P. , 134 B.R. 382, 390 (Bankr. N.D. Cal.
1991).] The United States Supreme Court bolstered these arguments when
it stated in Dewsnup v. Timm that pre-Code practice remains in force absent
specific direction to the contrary. [ FN:
Dewsnup v. Timm , 502 U.S. 410 (1992).]
Commentators also have supported the new value exception by policy analysis. They have
noted the congressional intent to promote rehabilitation of financially distressed entities, a value
furthered by allowing failing businesses to accept fresh contributions of capital. [ FN: See , e.g. , In re Elmwood Inc.
, 182 B.R. 845, 852 (D. Nevada 1995), citing NLRB v. Bildisco & Bildisco , 465 U.S. 513
(1984); Coones v. Mutual Life Insurance of New York , 168 B.R. 247 (D. Wyo. 1994), citing
In re Johnson , 101 B.R. 307 (Bankr. M.D. Fla. 1989).]
Considering that some courts have confirmed new value plans for companies that have
questionable economic value, [ FN: See ,
e.g. , In re U.S. Truck Co. , 800 F.2d 581 (6th Cir. 1986) (old equity most likely
is only party that would pay anything to invest in debtor); In re Potter Material Service,
Inc , 781 F.2d 99 (7th Cir. 1986); Bank of America, Illinois v. 203 N. LaSalle St. Partnership ,
195 B.R. 692 (N.D. Ill. 1996), aff ’g 190 B.R. 567 (Bankr. N.D. Ill. 1995). See also
Richard L. Epling, "The New Value Exception: Is There a Practical Workable Solution? " 8
Bankr. Dev. J. 335 (1991) (value of equity positions on date of confirmation often is
zero).] this policy consideration seems to play a central role in some
reorganizations.
The Los Angeles Lumber test has provided the basis for inquiry by those courts
that have endorsed the new value principle’s continuing viability. [ FN: See , e.g. , In re Montgomery
Court Apartments of Ingham County, Ltd. , 141 B.R. 324, 344 (Bankr. S.D. Ohio 1992); In
re Woodscape Ltd. Partnership , 134 B.R. 165, 175 (Bankr. D. Md. 1991). But see Charles
W. Adams, "New Capital For Bankruptcy Reorganizations: It ’s the Amount that Counts, "
89 Nw. U. L. Rev. 411,429 (1995) (questioning utility of Los Angeles Lumber test). Accord ,
Bruce A. Markell, "Owners, Auctions, and Absolute Priority in Bankruptcy Reorganizations, " 44
Stan. L. Rev. 69 (1991); John D. Ayer, "Rethinking Absolute Priority After Ahlers , " 87 Mich. L.
Rev. 963 (1989).] While the analysis varies, the factors have remained
reasonably constant. Courts generally have considered whether the contribution is 1) new; 2)
substantial; 3) money or money’s worth; 4) necessary for a successful reorganization; and
5) reasonably equivalent to the interest obtained. [
FN: See e.g ., In re Bonner Mall Partnership , 2 F.3d 899, 908 (9th Cir.
1993); In re U.S. Truck Co. , 800 F.2d 581,588 (6th Cir. 1986); In re
Woodbrook Assocs. , 19 F.3d 312, 320 (7th Cir. 1994); Berkeley Federal Bank & Trust v.
Sea Garden Motel and Apts. (In re Sea Garden Motel and Apts.) , 195 B.R. 294, 300
(D.N.J. 1996).] Courts have applied these criteria on acase by case basis.
[ FN: In re Woodbrook Assocs. , 19
F.3d 312 (7th Cir. 1994) (case by case analysis necessary); In re Snyder , 967 F.2d 1126,
1131-32 (7th Cir. 1992); In re Elmwood Inc. ,182 B.R 845 (D. Nev. 1995); In re
SM 104 Ltd. , 160 B.R. 202, 229 (Bankr. S.D. Fla. 1993).] While not all
courts have engaged in the breadth of analysis that the test might properly entail, most have
strictly construed the requirements. [ FN:
See In re Montgomery Court Apts , 141 B.R. 324, 344 (Bankr. S.D. Ohio 1992)(failed
to show reasonable equivalence); In re Creekside Landing, Ltd , 140 B.R. 713 (Bankr.
M.D. Tenn. 1992) (equity must bear new economic risk in form of balance sheet assent), In
re BMW Group I , 168 B.R. 731 (Bankr. W.D. Okla. 1994) (no evidence that it would not
bring higher price on market). But see In re U.S. Truck Co. , 800 F.2d 581 (6th Cir.
1986) (test not strictly applied).]
Two pre-Ahlers court of appeals decisions affirmed the confirmation of new value
plans. The debtor in Potter Material Service was a closely-held business that purchased,
manufactured, and sold building supplies and materials. [ FN: In re Potter Material Service Inc. , 781
F.2d 99 (7th Cir. 1986).] According to its plan, its sole shareholder would
contribute approximately $14,800 to pay 3% to a class of unsecured creditors and $20,000 to pay
the debtor’s attorneys. In addition, the shareholder would renew his $600,000 personal
guaranty. The bankruptcy court rejected the creditors’ evidence that valued the debtor
between $50,000 and $100,000. It found instead that the going concern value of the debtor,
taking all risks into account, was only between $10,000 and $15,000. [ FN: Id. , at 102-103. The lower courts
found that the higher estimations did not take into account such factors as the debtor ’s
negative earnings history and the volatility of the business.] Therefore, the
owners could retain an interest on the basis of their new contribution. The Court of Appeals for
the 7th Circuit upheld confirmation, stating that the
unsecured creditors failed to present evidence that the bankruptcy court’s valuation was
clearly erroneous. [ FN: Id. , at 104.
The guaranty was found to be an economic risk of "indeterminable value "although was deemed
to be valid consideration. A subsequent 7th Circuit panel
has called into question the holding of Potter on several bases, one of which was that a guaranty
might not qualify as a valid contribution under Ahlers . Kham & Nate ’s Shoes No. 2
Inc. v. First Bank of Whiting , 908 F.2d 1351, 1362 (7th Cir. 1990).]
Another pre-Ahlers case, U.S. Truck, [ FN: In re U.S. Truck Co. ,47 B.R. 923
(E.D. Mich. 1985), aff ’d , 800 F.2d 581 (6th Cir. 1986).] featured a
debtor that shipped automotive parts and supplies. Its plan of reorganization provided the former
sole shareholder with 100% of the shares of the reorganized entity in exchange for a $100,000
contribution. In light of the $100,000 monthly reported profits, the Teamsters Committee
contended the proposed contribution was grossly inadequate relative to the going concern value
of the entity and could not be considered essential to the success of the reorganization. The Court
of Appeals for the 6th Circuit upheld the plan confirmation
on the basis that the reorganized company was a "risky proposition" due to labor
instability and the volatility of the debtor’s industry, which rendered income
projectionsunreliable. [ FN: 800 F.2d at
588. The district court relied on testimony of the debtor ’s president, who argued that the
potential that the union would insist upon elimination of their present system of operations could
have a "devastating effect " on the business ’ profitability, and thus the president had to
estimate profitability conservatively. 47 B.R. at 942.] Potential liability on
the union’s damage claim and the deregulation of the industry also took their toll on the
debtor’s reputation in the general investment community, leaving the new shares with
nominal worth:
it is highly unlikely that any outside investor would now wish to invest in the debtor under the
present circumstances. The expert concluded that $100,000 was not only a fair market price but
that it probably was well above what the shares could be sold to the general public. [ FN: Id. , at 943.]
For these reasons, the district court adopted the view of the debtor’s expert witness
that the contribution was essential. [ FN:
"Conway had testified that the contribution was important, but not crucial. The Teamsters
Committee seized upon this distinction. The District Court found that to attempt to distinguish
between ‘important ’ and ‘crucial ’ is to engage in hairsplitting. " 800 F.2d at 588
n.10.] In reaching this result, both courts paid particular attention to the
fact that the objecting Teamsters presented no independent rebuttal evidence.
Since the Supreme Court's famous footnote in the Ahlers decision called into
question the survival of the new value exception, quite a few circuit court panels have speculated
on the survival of the new value exception and have divided over the question of whether it
survived the enactment of the Code. However, only the 9th
Circuit has issued a decision, Bonner Mall, which has addressed the new value issue
squarely. That court held that the exception survived. [
FN: In re Bonner Mall Partnership , 2 F.3d 899, 906 (9th Cir. 1993), cert.
granted , 114 S. Ct. 681, motion to vacate denied and dismissed as moot , 115 S. Ct. 386
(1994).]
In Bonner Mall, a creditor sought to lift the automatic stay on the basis that the
debtor could not confirm a plan in a reasonable amount of time because any plan contemplated
would involve participation by old equity. [ FN:
Id . See United Savings Assoc. of Texas v. Timbers of Inwood Forest Assocs., Ltd. , 484 U.S.
365 (1988).] When it ruled that lifting the stay was inappropriate, the
9th Circuit reviewed the absolute priority rule and its new
value "exception." The court held that "the doctrine is not actually an
exception to the absolute priority rule but is rather a corollary principle, or, more simply a
description of the limitations of the rule itself. It is . . . the set of conditions under which former
shareholders may lawfully obtain a priority interest in thereorganized venture." [ FN: Id. Conversely, had Congress
omitted the "on account of" language, this would have indicated an intent to prohibit former
equity owners from receiving or retaining property in cramdown plans. See Dewsnup v. Timm ,
502 U.S. 410 (1992) (emphasizing reluctance to overturn pre-Code practice in absence of explicit
Congressional instruction).] The court cited with approval the Los
Angeles Lumber criteria, as developed in pre-Code case law.
The Supreme Court agreed to review the Bonner Mall decision, which would have
laid this dispute to rest, but the parties settled the case and therefore the appeal was dismissed as
moot. At the very least, the Bonner Mall decision settled the uncertainty among the
courts in the 9th Circuit, which had issued conflicting
rulings on the subject. [ FN: See ,
e.g. , In re A.V.B.I. Inc. , 143 B.R. 738 (Bankr. C.D. Cal. 1992) (exception
dead); In re F.A.B. Ind. , 147 B.R. 763 (C.D. Cal. 1992) (exception lives); In re
Outlook/Century Ltd. , 127 B.R. 650 (Bankr. N.D. Cal. 1991) (exception dead); In re
Triple R Holdings, L.P. , 134 B.R. 382 (Bankr. N.D. Cal. 1991) (exception
lives).]
No other circuit court decision has addressed the issue directly since Ahlers.
However, apparently not discouraged by the Supreme Court’s equivocation in
Ahlers, the Court of Appeals for the 8th Circuit
continued to presume, without discussion or direct conclusion, that the exception was viable. In
Blankenmeyer, [ FN: In re
Blankenmeyer , 861 F.2d 192 (8th Cir. 1988) .] the family farm owners
proposed to retain an interest in their farm without satisfying their mortgagee’s deficiency
claim in full. The bankruptcy court denied confirmation and the district court affirmed. Upholding
the district court’s ruling, the 8th Circuit stated that
the debtor failed to show that the "junior class contributed something reasonably
compensatory and measurable to the reorganization enterprise." [ FN: Id. , at 194. But see In re
Lumber Exchange Building Ltd. Partnership , 968 F.2d 647 (8th Cir. 1992) (affirming on
bankruptcy court ’s dismissal of case on classification grounds, thus not addressing
bankruptcy court ’s holding that new value exception had no force under Bankruptcy
Code).] The court cited Ahlers only for a basic statement of the
fair and equitable requirement.
Likewise, in Anderson, [ FN:
Anderson v. Farm Credit Bank of St. Paul (In re Anderson) , 913 F.2d 530 (8th Cir.
1990).] the grain farm owner debtors proposed a similar plan and the
undersecured mortgagee moved for relief from stay. The debtor testified that she needed the land
to reorganize successfully and that her relatives would provide a small amount of new capital with
"no strings attached." [ FN:
Id. , at 532.] The bankruptcy judge lifted the stay and the district
court affirmed because the debtors failed to show any realistic prospect of reorganization. In its
review, the 8th Circuit agreed that the debtors failed to
meet their burden of proof. However, the court also stated, with apparent approval, that
"the district court recognized the continuing validity of the ‘new value’
exception to the absolute priority rule, but concluded the Andersons’ vague testimony
concerning the contribution by unnamed relatives of an unspecified amount of moneywas
insufficient to meet their burden of showing a contribution that was reasonably compensable and
measurable," and cited Ahlers and Blankenmeyer for this general
proposition. [ FN: Id. , at
532-533.]
Unlike the 8th Circuit, the
7th Circuit deemed the continuing viability of the new
value exception an open question after Ahlers, notwithstanding its prior presumption of
the exception’s continued existence in Potter Material Service; "a point of
law merely assumed in an opinion, not discussed, is not authoritative." [ FN: In re Stegall , 865 F.2d 140 (7th Cir.
1989), citing Pennhurst State School Hospital v. Halderman , 465 U.S. 119, n.29
(1984).] In Stegall, a family farm case, the court assessed in
detail the owners’ proposed contribution. [
FN: Id. , at 142-145.] The only quantified contribution
the Stegalls offered was the value of their crops, which was found to constitute only $2,000 of
new capital. [ FN: Id. , at 143, aff
’g 85 B.R. 510 (C.D. Ill. 1987), aff ’g 64 B.R. 296 (Bankr. C.D. Ill. 1986). The
Stegalls argued that the value of their crops surpassed $20,000. The court did not accept this
number. Moreover, while the Stegalls claimed they would make additional contributions, e.g.,
their pigs, they offered no proof of the value of such livestock.] The
7th Circuit affirmed the lower courts’ findings that
the owners’ proposed new value was not sufficient, regardless of whether the new value
exception survived.
When it was called to rule on another farm case, In re Snyder, the
7th Circuit suggested that "a settled canon of
interpretation" strongly supported the continuing viability of the exception. [ FN: In re Snyder , 967 F.2d 1126, 1129
(7th Cir. 1992), citing Midlantic Nat ’l Bank. v. New Jersey Dep ’t of
Environmental Protection , 474 U.S. 494 (1986) and Dewsnup v. Timm , 112 S. Ct. 773
(1992).] In addition, the court seemed to endorse the notion that the new
value exception actually is a wholly consistent corollary to the absolute priority rule. The court
also highlighted the "strong policy arguments" supporting the new value exception,
and directly took issue with the arguments of another 7th
Circuit panel that concluded otherwise. [ FN:
Id. , criticizing Kham & Nate ’s Shoes No. 2 Inc. v. First Bank of Whiting ,
908 F.2d 1351 (7th Cir. 1990) (arguing that creditors would not withhold consent if an insolvent
business were worth reorganizing) .] However, after putting forth its litany
of arguments, the court stopped short of ruling that the new value exception remained in effect,
and again reserved the issue for another day. Even if the new value exception remained vital, the
court reasoned, the debtor’s offer to obtain a release of lien on farm equipment and to pay
the value of the machinery to creditors over five years was not an up-front infusion of capital and
was not substantial. While the debtors also offered to make a $30,000 cashpayment, this also was
deemed insubstantial, for it represented a mere 2.7 % of the debt to unsecured creditors and 3.3%
of the mortgagee’s deficiency claim. [
FN: Id. "We cannot say that the determination as to whether an infusion of
new capital is ‘substantial ’ will always hinge on a comparison to the total amount of
unsecured debt. There is no mathematical formula for resolving the substantiality issue, and it will
depend on the circumstances of the individual case. In the instant case, where the disparity
between the contribution and the debt is so extreme, we agree with the courts below that there is
no need to proceed any further and that the proposed contribution is not substantial. " Id.
, at 1131-1132.]
When the 7th Circuit considered the new value
exception again in the Woodbrook Associates single asset case in 1994, it
suggested that the questionable exception had become better known as a "corollary,"
yet it concluded that it did not need to resolve the underlying legal question to uphold the lower
courts’ dismissal of the case. [ FN:
In re Woodbrook Assocs. , 19 F.3d 312, 320 (7th Cir. 1994) .]
The lower courts had found that the partners’ proposed $100,000 contribution was an
insubstantial token infusion and an unfair price for the right to participate in the plan. As in
Snyder, the Woodbrook panel compared the partners’ proposed cash
infusion to the amount of unsecured debt (and found that it would constitute 3.8%) but reiterated
that the comparison was not dispositive of insubstantiality. [ FN: However, in upholding the dismissal of the
case prior to confirmation hearing, it went on to say that "a bankruptcy court need not engage in
any further analysis of substantiality where the disparity between the proposed cash infusion and
unsecured debt is so extreme. " Id.]
In the bankruptcy case of an energy cooperative association, Wabash Valley Power
Association, the 7th Circuit again revisited
the history and policy surrounding the absolute priority rule and new value exception in great
detail, in a somewhat favorable light. [ FN:
In re Wabash Valley Power Ass ’n , 72 F.3d 1305 (7th Cir.
1995).] Yet, the court concluded that it had no reason to decide the issue.
Although the bankruptcy court had found that member cooperatives had made sufficient new
value contributions to justify their continuing involvement on the board of the debtor association,
the 7th Circuit held that the members were not equity
holders. Therefore, the analysis was inapplicable.
The 7th Circuit’s decision in Kham &
Nate's Shoes No. 2 diverges from the aforementioned
7th Circuit opinions that have addressed the subject. It
reflects significant apprehension about the vitality of the new value exception. [ FN: Kham & Nate ’s Shoes No. 2 Inc.
v. First Bank of Whiting , 908 F.2d 1351 (7th Cir. 1990). See also Piedmont Assoc. v. Cigna
Property & Casualty Ins. Co. , 132 B.R. 75 (N.D. Ga. 1991) (suggesting that plain language
of Code and congressional intent preclude exception ’s existence, but declining to rule
definitively)] The court analyzed the history of the new value exception
and suggested that it was eviscerated by the codified fair and equitablestandard. [ FN: Kham & Nate ’s Shoes, No.2 ,
908 F.2d at 1360. The court also reasoned that the new value doctrine no longer was necessary to
control minority holdouts due to the implementation of class voting and rule. If the proposed
participation of old equity were reasonable and valuable, the majority of creditors would have
consented to the plan. Accord In re Bryson Properties, XVIII, , 961 F.2d 496, 504 (4th
Cir.) cert. denied , 113 S. Ct. 191 (1992). But see In re Snyder , 967 F.2d 1126
(7th Cir. 1992) (reasons besides lack of value might prevent creditors from supporting
plan).] However, in reversing the confirmation of the plan, the Court again
stopped short of ruling on the exception’s demise, for the proposed contribution, the
owners’ guaranty on a $435,000 loan, was an "intangible, inalienable, and
unenforceable" form of consideration that would be insufficient under Ahlers.
[ FN: Kham & Nate ’s Shoes,
No. 2, , 908 F.2d at 1362.]
Other circuit court panels also have expressed doubts that the exception remains good law,
and similarly have declined to decide the issue. In Bryson Properties, the court
expressed concern that equity participation entailed an exclusive right to bid; this, in itself, might
be an impermissibly-retained property right in contravention of the absolute priority rule. [ FN: See In re Bryson Properties, XVIII ,
961 F.2d 496 (4th Cir.), cert. denied , 113 U.S. 191 (1992).] The court
went on to say, however, that even if the new value exception did exist, "it would not be so
expansive as to apply under the facts of this case . . . Here, the debtors have carried their
opportunity for self-dealing too far." [
FN: Id. , at 505.] The Court of Appeals for the
5th Circuit ruled that the new value exception did not
survive enactment of the 1978 Code, but on reconsideration the circuit withdrew that portion of
the opinion. [ FN: In re Greystone
III Joint Venture , 995 F.2d 1274 (5th Cir. 1991), cert. denied , 113 S. Ct. 72
(1992).]
In what might be the most neutral statement on the matter, the Court of Appeals for the
10th Circuit affirmed a bankruptcy court’s decision
denying confirmation of the new value plan of farm owners. [ FN: In re Drimmel , 987 F.2d 1506 (10th
Cir. 1993).] The bankruptcy court had held that the debtors did not prove
that their new contribution would have qualified, but more importantly, the new value exception
did not survive the Code’s enactment. Without taking any evident position on the
bankruptcy court’s latter holding, the 10th Circuit
merely ruled that the debtors had not provided sufficient proof that they fulfilled the Los
Angeles Lumber requirements. [ FN:
Id. , at 1510.]
Without definitive guidance from the circuit courts on whether non-consensual new value
can be "fair and equitable," lower courts have adopted their own interpretations. As
stated previously, numerous bankruptcy courts have held that the new value exception/corollary
remainsgood law; of those, some have confirmed new value plans, often reversed by reviewing
courts. [ FN: Post- Ahlers cases in which
bankruptcy courts have used the new value exception or corollary in favor of the plan proponent
include, but are not limited to, the following: In re Bryson Properties, XVIII , 129 B.R.
440 (Bankr. M.D. N.C. ), rev ’d on other grounds , 961 F.2d 496 (4th Cir.) , cert.
denied , 113 S. Ct. 191 (1992); In re Greystone III Joint Venture , 102 B.R. 560 (Bankr.
W.D. Tex. 1989), aff ’d , 127 B.R. 138 (W.D. Tex. 1990), rev ’d on other
grounds , 995 F.2d 1274 (5th Cir. 1991), cert. denied , 113 S. Ct. 72 (1992); Kham & Nate
’s Shoes No. 2 Inc. v. First Bank of Whiting , 104 B.R. 909 (N.D. Ill. 1989) (affirming
confirmation), rev ’d , 908 F.2d 1351 (7th Cir. 1990) ; In re Sea Garden Motel
and Apts. , 195 B.R. 294 (D.N.J. 1996) (reversing confirmation of new value plan); Bank of
America, Illinois v. 203 N. LaSalle St. Partnership ,190 B.R. 567 (Bankr. N.D. Ill. 1995) , aff
’d 195 B.R. 692 (N.D. Ill. 1996); In re Elmwood Inc. , 182 B.R. 845, 852 (D.
Nevada 1995) (upholding confirmation) ; In re Green , 98 B.R. 981 (Bankr. 9th Cir.
1989) (reversing confirmation) ; In re Shepcaro , 144 B.R. 3 (Bankr. D. Mass. 1992);
In re Haas , 195 B.R. 933 (Bankr. S.D. Ala. 1996). Pre- Ahlers cases include, but are not
limited to, the following: In re Landau Boat Co ., 13 B.R. 788 (Bankr. W.D. Miss. 1981);
In re Roberts Rocky Mountain Equipment Co. , 76 B.R. 784 (Bankr. D. Montana 1987);
In re Eaton Hose and Fitting Co. , 73 B.R. 139 (Bankr. S.D. Ohio 1987); In re
Brown ’s Industrial Uniforms , 58 B.R. 139 (N.D. Ill. 1985); In re Henke , 90 B.R.
451 (Bankr. D. Mont. 1988). See p. 9, n. 26 & n. 28 for citations to lower court decisions
stating that the new value exception or corollary survives but the plan proponents failed to meet
the standards.] A fair number of lower courts have ruled to the contrary,
holding that the new value exception did not survive enactment of the 1978 Bankruptcy Code.
[ FN: In re A.V.B.I. Inc. , 143 B.R. 738,
741 (Bankr. C.D. Cal. 1992) (consensual new value plans should be encouraged, but statutory
language and legislative history reveal that new value exception was omitted intentionally from
§1129(b)); In re Outlook/Century, Ltd. , 127 B.R. 650, 656 (Bankr. N.D. Cal.
1991) (statute ’s plain language precludes new value exception); In re Lumber
Exchange Ltd. Partnership , 125 B.R. 1000 (Bankr. D. Minn. 1991) (granting relief from stay for
lack of likelihood of confirmation, holding that new value exception had no force under Code), aff
’d , 134 B.R. 354 (D. Minn. 1991), aff ’d , 968 F.2d 647 (8th Cir. 1992) (not
addressing absolute priority or new value issues); Pennbank v. Winters (In re Winters) ,
99 B.R. 658, 663 (Bankr. W.D. Pa. 1989) ( "Congress deliberately did not mention "infusion of
new capital " as consideration in applying the fair and equitable test " when it changed to class
voting); In re Ribs Auto Sales Inc. , 140 B.R. 390 (Bankr. E.D. Va. 1992) (stating in
dictum that there is no exception to absolute priority rule); In re Rudy Debruycker Ranch
Inc. , 84 B.R. 187 (Bankr. D. Mont. 1988); In re Maropa Marine Sales Service &
Storage Inc. , 90 B.R. 544 (Bankr. S.D. Fla. 1988). See also In re Trevarrow Lanes Inc.
, 183 B.R. 475, 492 (Bankr. E.D. Mich. 1995) ( "There is no exception to the absolute priority
rule, " but judge can use discretion under section 1129(b) to determine what the fair and equitable
requirement entails, on either a case-specific or generic basis).]
Summary of Case Law and Conclusions
While the issue has percolated through the courts, neither the Supreme Court nor any of the
circuit courts, other than the 9th Circuit, has brought
resolution to this question left open by the statute and the legislative history. With little
authoritative guidance to provide consistency, the uncertainty has generated an abundance of
litigation. Not surprisingly, lower courts have reached a variety of results.
A review of the case law reveals an additional facet of the problem. Concerned that
management and shareholders would squeeze out intermediate level creditors and mis-allocate
value, the Supreme Court originally enunciated the "fixed principle" of absolute
priority in thecontext of equity receiverships and railroad reorganizations. [ FN: See Northern Pacific Ry. v. Boyd , 228 U.S.
482 (1913); see also In re Wabash Valley Power Ass ’n , 72 F.3d 1305 (7th Cir.
1995); Douglas G. Baird and Thomas H. Jackson, "Bargaining After the Fall and the Contours of
the Absolute Priority Rule, " 55 U. Chi. L. Rev. 738 (1988); John D. Ayer, "Rethinking Absolute
Priority After Ahlers , " 87 Mich. L. Rev. 963, 969 (1989).] Potential
exceptions to this rule were initiated in the same context. [ FN: Kansas City Terminal Ry. Co. v. Central
Union Trust Co. , 271 U.S. 445, 455 (1926).] However, the legal
development of the new value exception primarily has been shaped by small chapter 11 cases:
family farms, [ FN: See , e.g. ,
Norwest Bank Worthington v. Ahlers , 485 U.S. 197 (1988); In re Drimmel , 987 F.2d
1506 (10th Cir. 1993); In re Anderson , 913 F.3d 530 (8th Cir. 1990); In re
Snyder , 967 F.2d 1126 (7th Cir. 1992); In re Stegall , 865 F.2d 140 (7th Cir. 1989);
In re Blankenmeyer , 861 F.2d 192 (8th Cir. 1988).] single asset
cases, [ FN: See , e.g. , In
re Bonner Mall Partnership , 2 F.3d 899 (9th Cir. 1993), cert. granted , 114 S. Ct. 681,
motion to vacate denied and dismissed as moot , 115 S. Ct. 386 (1994); In re Lumber
Exchange Ltd. Partnership , 968 F.2d 647 (8th Cir. 1992); In re Greystone III Joint
Venture , 102 B.R. 560 (Bankr. W.D. Tex.), aff ’d , 102 B.R. 138 (W.D. Tex.), rev
’d , 995 F.2d 1274 (5th Cir. 1991); In re SM 104, Ltd. , 160 B.R. 202 (Bankr.
S.D. Fla. 1993); In re Pine Lake Village ; In re Bjolmes Realty Trust , 134 B.R.
1000 (Bankr. D. Mass. 1991) ; In re Woodscape Ltd. Partnership , 134 B.R. 165 (Bankr.
D. Md. 1991) ; In re Creekside Landing, Ltd , 140 B.R. 713 (Bankr. M.D. Tenn. 1992)
.] and closely held businesses. [
FN: See , e.g. , Kham & Nate ’s Shoes No. 2 Inc. v. First Bank of
Whiting , 908 F.2d 1351 (7th Cir. 1990); In re Potter Material Service Inc. , 781 F.2d 99
(7th Cir. 1986); In re U.S. Truck Co. , 800 F.2d 581 (6th Cir.
1986).] In these cases, management and equity often are one and the same.
[ FN: See Norwest Bank Worthington v.
Ahlers , 485 U.S. 197 (1988); Case v. Los Angeles Lumber Products Co. , 308 U.S. 106 (1939);
In re Drimmel , 987 F.2d 1506 (10th Cir. 1993); Kham & Nate ’s Shoes, No.
2 Inc. v. First Bank of Whiting , 908 F.2d 1351 (7th Cir. 1990). See also Douglas G. Baird and
Thomas H. Jackson, "Bargaining After the Fall and the Contours of the Absolute Priority Rule, "
55 U. Chi. L. Rev. 738 (1988). But see Raymond T. Nimmer, "Negotiating Bankruptcy
Reorganization Plans: Absolute Priority and New Value Contributions, " 36 Emory L. J. 1009,
1060 (shareholders exercise indirect influence over management).] When
courts have confirmed new value plans for small businesses, they have seemed more concerned
about whether equity has received something for nothing, regardless of whether the enterprise
itself is worthless. [ FN: The recently
confirmed (and affirmed) plan in the single asset case In re 203 N. LaSalle St. Partnership
provides an interesting example. Bank of America, Illinois v. 203 N. LaSalle St. Partnership , 190
B.R. 567 (Bankr. N.D. Ill 1995), aff ’d , 195 B.R. 692 (N.D. Ill. 1996). The debtor had
$58 million of unsecured debt, $38,469,112 excluding insiders ’ debt. Old equity holders
offered $3 million in cash and a $1.25 million letter of credit, estimated together to have a present
value of $4.1 million. The court found that the contribution "easily " was reasonably equivalent to
the equity interest received because the partners ’ new interest would be worthless on the
market, and would not bring any return in the near or distant future (even if the enterprise
survived for an additional ten years, the entire proceeds of any sale or refinancing would go to the
bank); the partners sought to retain their interests only for the significant tax consequences, not
because their equity positions had any intrinsic value. Id. , at 588. The district court
upheld the confirmation.] The courts face overriding considerations of
whether small, non-viable entities can be pushed out of chapter 11 quickly. New value exception
litigation is oneway to address these issues, but it is, at best, an indirect method. Notably, chapter
XI of pre-Code law, which controlled the smaller reorganization cases, had no absolute priority
rule, in part because it would have eliminated reorganization in nearly all cases. [ FN: "[I]n recognition of the fact that prior owners
may sometimes be the best ‘buyers ’ of a reorganized corporation, courts are reluctant to
squeeze the old owners out entirely [citation omitted]. This reluctance is especially evident when
the debtor is a closely held corporation or a sole proprietorship. " In re Wabash Valley
Power Ass ’n , 72 F.3d 1305 (7th Cir. 1995).] Case management, if
there was to be any, was accomplished in other ways. It may be that small and single asset cases
should be scrutinized more carefully, but the absolute priority rule may be the wrong tool to do
so. [ FN: This might be accomplished more
directly through other means, such as time limits for plan proposals, lifting exclusivity, and the
like.]
At the same time, due to size and complexity, the parties involved with a large or publicly
held debtor have stronger incentives to avoid cramdown litigation and the complicated valuation
procedures that litigation entails. They negotiate with this goal in mind. One commentator and
practitioner has noted, "the possible negative impact of the imposition of the cramdown
powers [are] so significant, that the cramdown power is used more as a
threat than as a club actually employed in confirming a plan of reorganization." [ FN: Richard F. Broude, "Cramdown and chapter
11 of the Bankruptcy Code: The Settlement Imperative, " 39 Bus. Law. 441
(1984).] In efforts to reach consensus, empirical studies indicate that
publicly held debtors routinely negotiate for plans that would not satisfy the absolute priority rule.
[ FN: Mark J. Roe, "Bankruptcy and Debt:
A New Model for Corporate Reorganization, " 83 Colum. L. Rev. 527, 536
(1983).] As a result, they ultimately make distributions to equity holders,
although consistent with the thrust of the absolute priority rule, equity’s retained interest
tends to be much smaller in the cases of insolvent companies. [ FN: Lynn M. LoPucki & William C.
Whitford, "Patterns in the Bankruptcy Reorganization of Large, Publicly Held Companies, " 78
Cornell L. Rev. 597, 611 (1993).]
To the extent that there is a substantial body of case law, albeit a conflicting one, that
provides a backdrop to these negotiations, it has been created in the rather incongruous context of
small chapter 11 cases. Thus, large chapter 11 debtors currently negotiate for consensual plans in
the shadow of law that not only is tremendously uncertain, but is made for entities with structures
and problems quite different than theirs.
Reasons for the Proposed Change
Any recommendation made by the Commission that would settle this uncertainty
would have a salutary effect on chapter 11 cases. Presently, extensive judicial efforts are
beingexpended for little gain. Litigation -- and the attendant costs and delays -- could be reduced,
and parties could negotiate for out-of-court settlements with greater certainty and speed.
The proposal is designed to maintain the balance between the need for capital to preserve
the business and its going concern value and the need to make certain that old equity pays a
market price for whatever ownership it buys in the reorganized company. The Working
Group’s proposal endorses the holding of the 9th
Circuit’s Bonner Mall decision insofar as it would allow old equity holders to
participate in a cramdown plan if they would not receive property "on account of"
their prior interests. To this extent, it would answer the question left open in Ahlers.
[ FN: This proposal would not in any way
affect the interpretation of the new value test employed in Ahlers . The Working Group did not
discuss the codification of an actual test. That would be left to case law interpretation and
development. Thus, for example, a new value contribution still would have to be in money or
money ’s worth, and "sweat equity " would not qualify.] The
Working Group did not want to foreclose beneficial equity participation that often can provide a
valuable source of capital to help fund a business’ reorganization. [ FN: "It makes no sense to suggest that the creditor
body can sell the equity in the reorganized debtor to anyone except the debtor ’s
pre-petition equity holders. Such a blanket rule would, in fact, doom many confirmable chapter 11
plans, since, as a practical matter, the debtor ’s pre-petition equity holders may be the only
persons who have any interest in buying the equity. " In re SM 104 Ltd. , 160 B.R. 202,
225 (Bankr. S.D. Fla. 1993) citing Elizabeth Warren, "A Theory of Absolute Priority, " 1991
Ann. Surv. Am. L. 9. "The fact that former partners may be among the successful bidders is as
irrelevant as the fact that former creditors may be among the successful bidders. " Overland Park
Merchandise Mart Partnership, 167 B.R. 647, 662 (Bankr. D. Kan. 1994) (denying confirmation
on other grounds).] The proposal is premised on a belief that it is
consistent with fundamental bankruptcy principles to permit equity to purchase an interest in the
reorganized debtor so long as creditors receive the going concern value to which they are entitled
under the circumstances. This was recognized by the early Act cases and, while the concept has
not been embraced universally, has remained a theme throughout this century’s case law.
At the same time, the Working Group seeks to provide additional assurance that confirmed
plans will not transfer value to old equity for less than full consideration in contravention of the
absolute priority rule. Therefore, the proposal recommends creditor and value protection beyond
those prescribed in Bonner Mall by permitting creditors to
propose competing plans. To some critics of the new value exception, the primary source of
concern has been the lack of competition in the process. This proposal should assuage the
concerns of courts and commentators who have objected to the notion of the new value exception
primarily on the basis that it would "permit insiders to acquire the ‘going
concern’ value of the debtor in a private sale at which no other bidders are allowed and in
which the seller (the impaired creditors) does not like the proposed purchase terms."
[ FN: In re A.V.B.I. Inc. , 143 B.R.
738, 747 (Bankr. C.D. Cal. 1992) (arguing that new value exception would provide third way to
confirm chapter 11 plan, similar to what is allowed in Chapters 12 and 13, but without protection
of the disposable income requirement); In re Bryson Properties , 961 F.2d 496, 504 (4th
Cir.) (partners inappropriately would receive exclusive bidding right), cert. denied , 506 U.S. 866
(1992).]
The notion that exclusivity might accompany a debtor’s move to cram down a plan is
not completely foreign. [ FN: "[I]f a
confirmable plan may be reached only through the termination of the exclusivity period, such a
measure should find ample justification in the policy as well as the test of the Bankruptcy Code. "
In re Homestead Partners, Ltd. ,197 B.R. 706, 714 (Bankr. N.D. Ga. 1996), citing
United Sav. Ass ’n v. Timbers of Inwood Forest Assocs. Ltd. , 484 U.S. 365 (1988)
[remaining citations omitted]. See also Richard L. Epling, "The New Value Exception: Is there a
Practical Workable Solution? " 8 Bankr. Dev. J. 335 (1991) (Code should be amended to clarify
that plan can include old equity participation with new value contribution as long as other debt
and equity classes and third parties have subscription rights).] Courts
already are permitted to shorten the exclusivity period for cause and even in the absence of a
specific provision, several courts have discussed that the proposal of a new value plan might
constitute such cause. [ FN: See ,
e.g. , In re Homestead Partners, Ltd. ,197 B.R. 706 (Bankr. N.D. Ga. 1996);
In re SM 104 Ltd. , 160 B.R. 202 (Bankr. S. D. Fla. 1993). Accord Edward S. Adams,
"Toward a New Conceptualization of the Absolute Priority Rule and its New Value Exception, "
1993 Det. C.L. Rev. 1445, 1486.] Because courts routinely grant
extensions of exclusivity, however, a mandatory exclusivity termination provision may bring about
a significant change that will afford a debtor less opportunity to shield itself from higher
valuations.
Overall, as compared to the current practices in some courts, the process envisioned by this
proposal would offer greater protection to creditors. Not only would the debtor have to show that
equity has offered new value in exchange for its interest, as always, but, if a party requested it, the
value of the assets would be tested by the market. This proposal would limit the problems
inherent in valuation disputes and would enhance the ability of the courts to determine what
constitutes a fair price by allowing the market to aid in the determination, rather than allowing the
pre-petition shareholders to set the price. [ FN:
See Richard L. Epling, "The New Value Exception: Is There a Practical Workable Solution? "
8 Bankr. Dev. J. 335 (1991); Kenneth N. Klee, "Cramdown II, " 64 Am. Bankr. L. J. 229, 232
(1990). According to one commentator, auction theory and reorganization practice both
demonstrate that the presence of competitive bidders increases creditor dividends. Former owner
involvement evidences confidence that the debtor has positive value and sets a minimum price.
Bruce A. Markell, "Owners, Auctions and Absolute Priority in Bankruptcy Reorganizations, " 44
Stan. L. Rev. 69, 72, 73 (1991). Accord Edward S. Adams, "Toward A New Conceptualization
of the Absolute Priority Rule and its New Value Exception, " 1993 Det. C.L. Rev. 1445, 1486
(central to possibility of proper valuation will be third parties whose bids will compete with those
offered by debtor. Debtor ’s right to exclusivity should be eliminated in context of
cramdown plans and self-appraisal structure should be established to set minimum
price).]
This proposal also would protect creditor interests more than some courts’ current
practice of using an equity auction at confirmation when there is no other market for the equity.
[ FN: In re Homestead Partners,
Ltd. , 197 B.R. 706 (Bankr. N.D. Ga. 1996) (endorsing equity auction); In re Hickey
Properties, Ltd. , No. 94-10180, 1995 WL 264023 at *3 (Bankr. D. Vt. March 23, 1995) (plan
must provide for sale of equity interest to highest bidder at auction); In re Overland Park
Merchandise Mart Partnership , 167 B.R. 647 (Bankr. D. Kan. 1994) (auctioning of controlling
share of equity acceptable, but minimum bid insufficient); In re Ropt Ltd. Partnership ,
152 B.R. 406 (Bankr. D. Mass. 1993) (ordering equity auction); In re Bjolmes Realty
Trust , 135 B.R. 1000, 1010-1012 (Bankr. D. Mass. 1991) (ordering equity auction). But see
SM 104 Ltd. ,160 B.R. 202, 226 (Bankr. S.D. Fla. 1993) (equity auction unrealistic due to thin
market and securities regulations).] In those circumstances, the equity is
undervalued because of the market failure, but old equity escapes court review of the factors
normally required for plan confirmation, including the requirement that the price paid is
reasonably equivalent to the value received. Instead, the Working Group proposal would give
creditors two protections, in effect: market exposure in a functioning market, and court review in
a non-functioning market. The recommended procedure helps to ensure the integrity of the
bankruptcy process and it maintains a relationship between equity and creditors that is more in
keeping with the rules of absolute priority.
Because a party in interest could not terminate exclusivity (at least on the basis provided by
this proposal) until the debtor affirmatively sought confirmation of a cramdown plan that
implicated absolute priority concerns, this proposal does not curtail the opportunity or lessen the
incentives of the parties to bargain for a consensual plan. [ FN: Even when exclusivity is lifted, the
competition does not preclude the possibility of a consensual plan. In the bankruptcy case In
re New Valley Corporation , Case No. 91-27704 (D.N.J.), the debtor, the secured creditors
committee, the unsecured creditors ’ committee and equity holders all filed separate plans
after the court declined to extend exclusivity. Equity was the longest hold-out, but the parties
reached agreement the night before the confirmation hearing. The court confirmed a consensual
plan.] Therefore, if a debtor cannot muster the votes for a plan that
includes continued equity participation but does not offer to pay creditors in full, the debtor has
several choices: it can attempt to put together a different consensual plan, it can modify the plan
to put it in technical compliance with the absolute priority rule and cram down the modified plan,
or it can move for cramdown on the new value plan and forfeit the exclusive right to propose the
terms of ownership. Under the latter scenario, parties in interest who believed that equity was
seizing value would be free to propose competing plans to deal with the business.
Competing Considerations
This proposal gives the creditors the tools to guard their rights by enabling them to propose
or support competing plans. It also gives them continued court review of plans to determine
equivalence of value received. But the proposal does not provide additional affirmative
protection.
When creditors proposed competing plans, there would be no guarantee that fellow creditors
would vote for those plans, even if their plans value the business more accurately. This means that
there may be instances when equity undervalues the business and creditors cannot object
effectively, and the interests of poorly informed or inactive creditors may be at risk. However, the
debtor still would be required to show that equity’s participation was on the basis of a fresh
contribution, based on the criteria that have been developed over time. In addition, a debtor could
not get to the cramdown stage without fulfilling the other requirements for plan confirmation set
forth in section 1129(a), which provide a variety of safeguards. One of those requirements is the
"best interest" test, i.e., under 11 U.S.C. § 1129(a)(7), the
creditors mustreceive at least as much as they would in a liquidation. At worst, creditors would
receive liquidation value, no different than under the present law.
The constraints on participation by old equity that this proposal contemplates may be
inadequate to balance the rights of the parties. This proposal would alter the parties’
bargaining rights that affect negotiations. Under this proposal, old equity holders may be the new
hold-outs and threaten to foil a consensual plan unless the creditors permit the equity holders to
participate. This already is a possibility under the current law, [ FN: See Lucian Bebchuk, "A New Approach to
Corporate Reorganizations, " 101 Harv. L. Rev. 775, 780 (1988).] but the
possibility may be exacerbated if old equity explicitly has the right to participate in a plan over the
objections of creditors. As the studies cited earlier indicate, reorganization plans for publicly
traded companies routinely do not comport with the absolute priority rule. In efforts to avoid
cramdown, debtors must obtain affirmative votes from classes of equity and this often requires
that equity is paid at least its nuisance value. To the extent that the proposed provisions legitimize
the negotiating leverage of old equity holders, they might allow them to take something from the
reorganization at the expense of partially unpaid creditors. On the other hand, if old equity holders
actually were to invoke the new value exception, they would have to provide new value. In most
of the publicly held cases recently studied, old equity has tried to maximize its hold-up value, but
it has not offered additional new value. Thus, at least in the context of the publicly held debtor,
this proposal would not change negotiating positions based on hold-out powers.
If the law remains in its uncertain state, every new value plan may be an invitation to
litigation. Instead of encouraging reorganization or enhancing value, this uncertainty only
increases the leverage of the best-funded, most aggressive party who is willing to threaten the
success of the reorganization. Moreover, if old equity holders are denied the opportunity to invest
in troubled companies upon creditor insistence, this might cause the going concern value of
businesses to dissipate. The implications may be far reaching, as more companies fail, employees
lose jobs, and creditors lose even more in bad debts.
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