April 2013: Bankruptcy and Restructuring Update

by Quinn Emanuel Urquhart & Sullivan, LLP
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Seventh Circuit Extends New Value Exception. In In re Castleton Plaza, L.P., No. 12-2639 (7th Cir. Feb. 14, 2013), the Seventh Circuit became the first Court of Appeals to address whether the new value exception to the absolute priority rule articulated in Bank of America Nat’l Trust & Savs. Ass’n v. 203 North LaSalle Street P’ship, 526 U.S. 434 (1999), extends to insiders, holding that (i) the wife of an equity holder qualified as an insider under the Bankruptcy Code and (ii) “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.” Castleton, slip op. at *5.

In Castleton, George Broadbent (“George”) held a 98% direct and a 2% indirect equity interest in the debtor, Castleton Plaza, L.P. (“Castleton”). Id. at *2. Castleton was managed by The Broadbent Company, Inc. (“Broadbent”). Id. at *3. George’s wife, Mary Clare Broadbent (“Mary Clare”) owned a 100% equity interest in Broadbent and George served as its CEO, for which he received an annual salary of $500,000. Id. Castleton, which owed approximately $10 million to its only secured lender, EL-SNPR Notes Holding (“EL-SNPR”), filed its chapter 11 petition after failing to pay the balance due to EL-SNPR. Id. at *2.

Castleton proposed a plan of reorganization in which (i) it would pay $300,000 of the approximately $10 million owed to EL-SNPR, (ii) the remainder of the $10 million balance would be written down to $8.2 million, with the difference treated as unsecured, and (iii) the terms of the $8.2 million secured loan would be modified by, among other things, extending the term of payment for 30 years, deferring most payments until 2021 and reducing the interest rate. Id. at *3. Castleton’s proposed plan did not provide its creditors with any equity interest and, by excluding George from retaining any equity interest, appeared to accord with the absolute priority rule. Id. The plan did, however, provide that Mary Clare would receive 100% of the equity in the reorganized debtor in exchange for contributing $75,000. Id. EL-SNPR argued that the plan undervalued the debtor’s assets and the equity interest in the debtor was worth more than $75,000, and offered to pay $600,000 for the equity and to pay all creditors 100%, rather than the 15 cent recovery proposed by the Castleton plan. Id. at *4. Castleton rejected this plan, electing instead to accept Mary Clare’s offer, which had increased to $375,000. Id. The bankruptcy court rejected EL-SNPR’s argument that the debtor’s acceptance of Mary Clare’s offer should be conditioned on Mary Clare making the highest bid in an open competition, which led to the appeal and the Seventh Circuit’s certification of the case for direct appeal under 28 U.S.C. § 158(d)(2)(A). Id.

In its analysis, the Court noted that “[i]n 203 North LaSalle, the [Supreme] Court remarked on the danger that diverting assets to insiders can pose to the absolute priority rule.” Id. at *5. Applying the law to the facts before it, the Court reasoned that, though Mary Clare did not have a prior equity interest in the debtor, as a family member, she qualified as an insider under the definition in the Bankruptcy Code. Id. The Court noted that insiders are, in other contexts, such as in preference actions, equated with equity investors and that “there c[ould] be no doubt” that George would receive value, in the form of a continuation of his salary as CEO of the debtor’s manager and an increase in the family’s wealth, if Mary Clare were permitted to obtain equity in the debtor’s plan. Id. at *5-6. The Court also stated that in a situation where George had discretionary control over a trust and directed benefits to his spouse, such benefits would be viewed as income to George. Id. at *6 (noting that “[s]ince the exercise of a power of appointment is treated as income in tax law, it should be treated as income for the purpose of § 1129(b)(2)(B)(ii) too”).

The Court concluded that the absolute priority rule applied to Mary Clare, even though she did not hold a prior equity interest, because George had control over the plan on account of his equity holdings and would have received value as a result of those holdings under the proposed plan. Id. at *7. Competition, the Court concluded, could ensure that plans “offer creditors the best value” and is essential in situations like this to preventing the circumvention of the absolute priority rule and “the funneling of value from lenders to insiders.” Id. at *7.

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