In re Red Mountain Machinery Company, 448 B.R. 1 (Bankr. D. Ariz. 2011)
The creditor, holding both secured claims and unsecured deficiency claims, objected to the chapter 11 debtor’s reorganization plan on a number of grounds, most notably that: (1) the creditor’s unsecured claims were improperly gerrymandered from other unsecured claims merely because the claims were guaranteed by principals of the debtor and subject to equitable subordination claims in a pending adversary case; and, (2) the plan violated the absolute priority rule because the principals were receiving equity shares in the plan and had not contributed “new value.”
The court denied the creditor’s objections and confirmed the plan, finding that there was no impermissible gerrymandering, that there was sufficient new value to avoid violation of the absolute priority rule, and that the plan was feasible under the evidence provided.
The debtor, Red Mountain Machinery, an Arizona corporation founded in 1986, is in the business of renting earth-moving equipment to highway, commercial and residential builders. The only shareholders of Red Mountain are Owen and Linda Cowing. Since 2003, Red Mountain had been financed by a revolving line of credit issued by Comerica Bank, secured by Red Mountain’s equipment and other assets, and personally guaranteed by the Cowings. The company had been successful, until the economic downturn hit in 2007. Declining revenues in 2008 led to non-monetary defaults of the credit line, which led to a series of forbearance agreements and workout negotiations.
At that time, Mr. Cowing was diagnosed with leukemia, and the Comerica negotiations were turned over to Red Mountain’s chief financial officer. Cowing subsequently found secret e-mails between the CFO and Comerica, in which those parties allegedly planned to force Cowing into selling the business so that the CFO could purchase Red Mountain, and Comerica would finance the purchase. In June 2009, Cowing advised Comerica of his discovery of this plot, and that Red Mountain might have claims against Comerica. In August 2009, Comerica refused to approve payment of weekly expenses, including payroll, and within days, Red Mountain filed its bankruptcy petition. The alleged conspiracy became the subject of a still-pending adversary proceeding to equitably subordinate, disallow or offset Comerica’s claims.
Following a sale of part of Comerica’s collateral, the parties stipulated that Comerica’s total secured class 2 claim was $15.9 million, paid at a present value of $10 million as a result of Comerica’s section 1111(b) election, and Comerica’s class 7 unsecured deficiency claim was $9.8 million. Notably, Comerica’s class 7 claim was separated from class 8 general unsecured claims, wherein the remaining unsecured claimants were placed. The plan designated class 9 for any claims that would be subordinated as a result of the adversary proceeding.
Class 10 consisted of the equity ownership of the Cowings. The plan provided that their equity ownership would be extinguished and that on the effective date, the Cowings would contribute $480,000 cash payable on their administrative claim in exchange for 100 percent of the equity of the reorganized debtor. In addition, there was to be an exit loan facility for $1.25 million, to be funded by the Cowings. Together with the cash on hand, this would be more than enough cash to pay all administrative claims, including the Cowings’ claims. The only classes rejecting the plan were 2 and 7, both Comerica classes.
The debtor sought confirmation of its plan. Comerica objected, asserting, among other things: (1) that the classification of claims amounted to impermissible gerrymandering; and, (2) that the plan did not satisfy the new value corollary to the absolute priority rule with respect to the deficiency claim. The Bankruptcy Court denied the objections, and confirmed the reorganization plan. The Bankruptcy Court also summarily disposed of Comerica’s feasibility objections on the evidence provided.
Gerrymandering—Section 1122 of the Bankruptcy Code provides that a plan may place a claim or interest in a class only if that claim or interest is substantially similar to the other claims and interests in that class, i.e., dissimilar claims may not be in the same class. Comerica argued that its deficiency claim was placed in a class separate from all other unsecured claims in order to gerrymander the vote in favor of the plan.
The Bankruptcy Court held otherwise, because: (1) Comerica’s deficiency claim was personally guaranteed by the Cowings, whereas no other unsecured claim was so guaranteed; (2) only Comerica’s claim was involved in litigation that could result in the claim being equitably subordinated or offset by the debtor’s own claim against the bank (thus moving the claim to class 9); and (3) there was no motivation to gerrymander the claim, in any case, because other impaired classes had voted to accept the plan. The court therefore denied this objection.
Absolute Priority Rule—The so-called “absolute priority rule” is set forth in section 1129(b)(2)(B)(ii), and it provides that if a rejecting class of unsecured claims is not paid in full, then “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.” (Emphasis added.) In this case, the rejecting class was Comerica’s deficiency claim in class 7, and the junior class was the equity interest of the Cowings. Because Comerica’s deficiency claim was not paid in full and it had rejected the plan, the bank argued that the Cowings could not retain their equity interests merely “on account of” the fact that they owned those interests as of the bankruptcy filing.
The court cited Bonner Mall Partnership v. U.S. Bancorp Mortgage Co. (In re Bonner Mall Partnership), 2 F.3d 899 (9th Cir. 1993), for the “necessary logical corollary” to this rule—the “new value corollary” (sometimes called a “new value exception”)—that equity owners may receive equity interests “on account of” something other than their prior equity ownership, “such as on account of a contribution of new value.” In Bonner Mall, the Ninth Circuit enumerated five requirements that, if satisfied, would allow the former owners to participate in the reorganized debtor on account of substantial, necessary, and fair new value contribution, rather than on account of prior interests. The five requirements are that the new value contribution be: new; substantial; money or money’s worth; necessary for a successful reorganization; and reasonably equivalent to the value or interest received.
In a case subsequent to Bonner Mall, the U.S. Supreme Court addressed the new value corollary, in Bank of America National Trust & Sav. Ass’n. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 119 S.Ct. 1411, 143 L.Ed. 2d 607 (1999). The Supreme Court expressly declined to overrule the new value corollary, and while the Court did not define what “on account of” requires, the Court did hold that new value cannot be achieved when old equity has the exclusive right to propose a plan.
First, addressing 203 North LaSalle, the Bankruptcy Court ruled that exclusivity had expired in this case, thus paving the way for the new value corollary. The court analyzed each of the five requirements in turn. The court readily concluded that the $480,000 contribution was “new” and “money.” The court then noted the undisputed evidence that the debtor did not have access to cash to pay nearly $1 million in administrative claims, and that the Cowings’ personal infusion of cash was therefore “necessary to the reorganization” of the debtor. Comerica offered no evidence that the $480,000 was not substantial, so the court, looking at other cases, determined that the amount was indeed “substantial.”
The court then turned to the fifth requirement, that the interest received be “reasonably equivalent” to the contribution. The court determined that “the value of the interest being retained should be determined based on either a pro forma balance sheet of the reorganized debtor or a capitalization of the reorganized debtor’s projected income.” Because evidence had not been presented on these questions, the court undertook its own balance sheet analysis. The court concluded that the debtor would be insolvent on a balance sheet basis on the effective date of the plan, so that the equity interests would have zero value. The new value contributions of $480,000 and the $1.2 million loan facility far exceed zero, so the new contributions “substantially exceed” the new equity value. The court held that all five prongs of the new value corollary were satisfied, the absolute priority rule was not violated, and the reorganization plan was confirmed.
This decision is most notable on the issue of how claims are classified. Citing In re Loop 76, LLC, 442 B.R. 713 (Bankr. D. Ariz. 2010), the court held that guaranteed claims could be separately classified from other claims. The decision also may have provided debtors a roadmap to ensure that unsecured creditors that are unlikely to accept a proposed plan are separated from supporting creditors—i.e., to gerrymander votes. Relying on this decision, a debtor may seek to initiate equitable subordination adversary proceedings against a creditor in advance of proposing a plan with the primary purpose of “carving” such creditors into a separate class, only to later dismiss such cases.
Similarly concerning for creditors is the fact that, with little to no evidence on the issue, the court determined that equity interests in a reorganized debtor are essentially valueless (as will often be the case under the balance sheet approach), thereby opening the door to “old equity” seeking to contribute new value in exchange for ownership and control of a reorganized debtor. Creditors objecting to such schemes should present financial evidence as to the value of future equity.