The absolute priority rule ordinarily prevents a Chapter 11 debtor from distributing any money or property to junior creditors and old equity investors unless all senior creditors have first been paid in full. See 11 U.S.C. § 1129(b)(2)(B)(ii). Nevertheless, old equity investors may attempt to receive new equity in the reorganized debtor in consideration for providing new (post-bankruptcy) investments in the debtor. Such “new value” plans are sometimes permitted on the theory that the investors are receiving a distribution from the debtor in exchange for their new contribution, not on account of their old equity interests, and thus there is no violation of the absolute priority rule. The Supreme Court in Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434, 119 S.Ct. 1411 (1999), held that any new value plan must be market tested to ensure that the plan provides the best recovery to all creditors and does not unfairly advantage existing equity holders. Courts have usually interpreted the market test requirement to mandate a competitive bankruptcy auction or the termination of the debtor’s exclusivity period to file and solicit acceptance of a reorganization plan so that the would-be plan sponsors and parties-in-interest may file their own competing plans.

Recently, in In re Castleton Plaza, LP, 2013 WL 537269 (7th Cir. Feb. 14, 2013), the Seventh Circuit, as the first circuit court to address the issue in the context of an insider, extended 203 North LaSalle a step further and held that “[c]ompetition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider.” In Castleton Plaza, the 100 percent owner of the debtor caused the debtor to propose a plan of reorganization that, despite not paying the creditors in full, provided that the owner’s wife was to receive 100 percent of the new equity in the reorganized debtor in exchange for a $75,000 “new value” investment. One of the debtor’s creditors objected to the new value plan and offered to pay up to $600,000 for the reorganized debtor’s equity. After the wife increased her offer to $375,000, the bankruptcy court confirmed the debtor’s plan and rejected the creditor’s argument that there should be an open auction for the equity.

The Seventh Circuit reversed the bankruptcy court, holding that an insider of old equity should be treated the same as old equity and “[t]he absolute-priority rule therefore applies despite the fact that [the owner’s wife] had not invested directly in [the debtor].” The court further reasoned that “[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.” Thus, in accordance with 203 North LaSalle, the court held that because the absolute priority rule applies to insiders, “competition is essential” to ensure that the return to creditors is maximized. Accordingly, the Seventh Circuit remanded the case to the bankruptcy court with directions to open the proposed plan of reorganization to competitive bidding.

Who Should Be Interested?

The Castleton Plaza decision is of interest to secured lenders and also to creditors and owners in single-asset real estate cases, where such new-value plans are most often seen. In such a case, secured lenders should take comfort that neither the original borrower nor an insider of the original borrower will be able to retain control of the single-asset property without first marketing the property at auction, where the lender has the right to credit bid up to the full amount of its debt. See RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S.Ct. 2065 (2012) (holding that secured creditors have the right to credit bid regardless of whether the auction is pursuant to § 363 or under a plan of reorganization). More specifically, this decision further confirms a senior secured lender’s ability to bid for the new equity in a reorganized debtor and ultimately assume control of its real estate collateral in lieu of a foreclosure proceeding. Similarly, Castleton Plaza further restricts the opportunity for borrowers to attempt to retain control of a real estate asset by providing new value and cramming down the secured lender.

Why this is important?

Although Castleton Plaza involved a fairly obvious and outrageous attempt to circumvent the absolute priority rule, the decision helps clarify the Supreme Court’s decision in 203 North LaSalle as applied to new investments by insiders. Further, Castleton Plaza – the only circuit court opinion on this topic since 203 North LaSalle – goes a long way toward resolving the split among bankruptcy courts as to whether equity owners of a debtor can attempt to creatively avoid application of the absolute priority rule and continue to control the debtor post-bankruptcy through transfers to insiders. This decision protects the rights of senior creditors and ensures that an equity holder cannot indirectly continue to control the debtor after confirmation of a plan without first holding an auction of that equity with competitive bidding.