In re Castleton Plaza, LP,___F.3d__, 2013 WL 537269 (7th Cir. Feb. 14, 2013)
The United States Court of Appeals for the Seventh Circuit recently extended the "competition rule" to a new-value reorganization plan that proposed that an insider would end up as the owner of the reorganized debtor. The debtor’s equity holder had arranged for his wife to contribute the new value under the plan in order to become the equity holder of the reorganized debtor. In the first case to reach the Court of Appeals level on this issue, the Seventh Circuit ruled that a competitive process is necessary whenever a plan distributes an equity interest in the reorganized debtor to an insider while leaving an objecting creditor unpaid. In re Castleton Plaza, LP, __ F.3d __, 2013 WL 537269 (7th Cir. Feb. 14, 2013).
The decision is largely based on the "competition rule" created by the U.S. Supreme Court in Bank of America National Trust & Savings Assn. v. 203 N. LaSalle Partnership, 526 U.S. 434 (1999), which involved the debtor’s use of its exclusive rights to confirm a plan over the objections of its mortgage lender, and without exposing the terms of the plan to any competitive process. The Supreme Court overturned the plan, emphasizing that the insiders’ use of the debtor’s exclusive rights to become the equity holder of the reorganized debtor without any market testing of the plan through an opportunity for either competing bids or competing plans "renders the partners’ right a property interest extended ‘on account of’ the old equity position and therefore subject to an unpaid senior creditor class’s objections." Id. at 456.
In its Castleton decision, the Seventh Circuit expanded upon 203 N. LaSalle in two respects. It applied the competition requirement to insiders of the debtor and not just the debtor’s equity holders. It also required competition whether or not the debtor proposed its plan during the period in which it had the exclusive right to file a plan and regardless of who proposes the plan.
Castleton Plaza was a limited partnership whose sole asset was a shopping center in Indiana. The equity owner owned 98 percent of the equity interest in Castleton directly and held the remaining 2 percent indirectly. Castleton had financed its shopping center through a mortgage loan of $9.5 million, which matured before it filed for chapter 11 in 2011.
Castleton proposed a plan of reorganization that would pay the lender $300,000 and reduce the balance of the secured debt down to $8.2 million, with the approximately $1 million difference treated as unsecured debt. The secured debt would be extended for 30 years at a reduced interest rate and virtually no principal repayment for eight years. The loan terms would also be modified to eliminate certain lender protections, such as lockbox arrangements and approval rights. The plan proposed that the owner’s wife would make a new investment of $75,000 and become the owner of the new equity in Castleton. Unsecured creditors would receive a 15 percent distribution on their claims.
After the lender objected to the plan, the plan was amended to raise the amount of the new investment to $375,000. The lender requested that this proposed new investment be subject to competitive bidding, but the bankruptcy court ruled that this was not necessary because the wife was not an equity holder in Castleton, and section 1129 (b)(2)(B)(ii) of the Bankruptcy Code deals only with the holder of any claim or interest that is junior to the impaired creditor’s claim. The plan was confirmed, but the bankruptcy court certified a direct appeal of the issue to the Seventh Circuit.
In reversing the decision of the bankruptcy court, the Seventh Circuit relied on a broad reading of the 203 North LaSalle decision. It acknowledged that the Supreme Court’s decision did not interpret section 1129(b)(2)(B)(ii), which does not deal with new-value plans, but the competition rule was intended to curtail evasion of the absolute priority rule. As Chief Judge Easterbrook explained:
"A new-value plan bestowing equity on an investor’s spouse can be just as effective at evading the absolute-priority rule as a new-value plan bestowing equity on the original investor. For many purposes in bankruptcy law . . . an insider is treated the same as an equity investor. Family members of corporate managers are insiders under § 101(31)(B)(vi). In 203 North LaSalle the Court remarked on the danger that diverting assets to insiders can pose to the absolute priority rule. . . . It follows that plans giving insiders preferential access to investment opportunities in the reorganized debtor should be subject to the same opportunity for competition as plans in which existing claim-holders put up the new money."
Id. at 5 (internal citations omitted).
The Seventh Circuit pointed out the ways in which the existing equity holder would benefit from the new equity to be acquired by his wife, including his continued $500,000 per year salary, as well as the increase in the family’s wealth from acquiring the new equity interest in reorganized Castleton at below market value. Accordingly, Chief Judge Easterbrook concluded that the "absolute-priority rule therefore applies despite the fact that [the wife] had not invested directly in Castleton. This reinforces our conclusion that competition is essential." Id. at 6-7.
The opinion proceeded to state the court’s view that application of the competition rule was required regardless of whether Castleton had proposed the plan during its exclusivity period and regardless of who proposed the plan. "Competition helps prevent the funneling of value from lenders to insiders, no matter who proposes the plan or when. An impaired lender who objects to any plan that leaves insiders holding equity is entitled to the benefit of competition. If, as Castleton and [the insiders] insist, their plan offers creditors the best deal, then they will prevail in the auction. But if, as [the lender] believes, the bankruptcy judge has underestimated the value of Castleton’s real estate, wiped out too much of the secured claim, and set the remaining loan’s terms at below market rates, then someone will pay more than $375,000 (perhaps a lot more) for the equity in the reorganized firm." Id. at 7.
At least in the Seventh Circuit, a court cannot confirm a plan through which insiders gain new equity interests in the reorganized debtor over creditor objection without subjecting the proposed capital contribution to a competitive process. The
Castleton decision expands the requirement of competition beyond a plan utilizing the debtor’s exclusivity rights to any plan in which insiders acquire a new equity interest. Unclear in the decision is why the lender did not file its own competing plan, and whether filing a creditor’s competing plan would satisfy the Seventh Circuit’s requirement of competition. It remains to be seen whether this opinion could be subject to further expansion by requiring auctions or other forms of competition for all new-value plans, even for plans that do not grant any new equity interests to insiders.