An Insider’s Guide to Evading Absolute Priority? Seventh Circuit: New value competition requirements apply to insiders

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In Chapter 11 bankruptcy cases, the absolute priority rule requires a debtor’s creditors be paid in full before equity investors receive any value. However, existing equity investors occasionally seek to invest new money in the plan of reorganization process and argue that such investment justifies retention of equity in the reorganized company; equity which otherwise would pass to impaired creditors. In 1999, the Supreme Court examined this “new value” argument, holding that valuing a new investment requires competition: if a reorganization plan rewards a new investment with equity in the reorganized company, other potential investors must be allowed to bid to determine the market value of that equity. See Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999). So long as the equity is valued through an auction and the equity investor pays the market-set rate, the absolute priority rule is not violated.

Since 203 North LaSalle, Bankruptcy judges have disagreed on whether the absolute priority rule bars insiders from purchasing equity absent this competitive process. The argument: absolute priority requires creditors be paid in full before equity investors receive anything, an insider is not an equity investor, therefore the rule does not apply and an auction is unnecessary. In In re Castleton Plaza, LP, 2013 U.S. App. LEXIS 3185 (7th Cir. 2013), the Seventh Circuit clarified the reach of the competitive process and the absolute priority rule, requiring insiders bear the same burdens as equity investors.

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