Under the absolute-priority rule, unpaid creditors normally receive the equity in a reorganized business. If a plan of reorganization proposes a “new value” investment in exchange for equity, however, the rule does not strictly apply. In the case of Bank of American National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, the Supreme Court held that because the absolute-priority rule does not protect impaired creditors in “new value” plans, competition is essential when a plan of reorganization gives an insider the option to purchase equity for new value.

What happens, however, when an individual does not strictly own an equity interest in the company, yet the net effect of the “new value” plan would be a windfall for the original equity holders?

The Seventh Circuit recently delivered the opinion of In re Castleton Plaza, LP, in which the debtor proposed a plan wherein his spouse offered to invest $375,000 of new value for 100% of the equity in the reorganized company. Though the plan nominally left the debtor empty-handed, the largest impaired creditor cried foul after its offer of a $600,000 investment was rejected by the debtor.

The bankruptcy court held that because the spouse was not an equity holder, no competition for the new value plan was necessary. The Seventh Circuit, on direct appeal, reversed, finding that “a new-value plan bestowing equity on an investor’s spouse can be just as effective in evading the absolute-priority rule as a new-value plan bestowing equity on the original investor.” The court noted LaSalle’s warning of the danger that diverting assets to insiders can pose to the absolute-priority rule, and held that for many purposes in bankruptcy law, an insider is treated the same as an equity investor. Thus, because family members of corporate managers are insiders under § 101(31)(B)(vi), competition for the new-value plan was necessary under LaSalle.

Castleton stands out for two important reasons. First, the court expanded the scope of who may be considered an equity investor or an insider for purposes of a plan of reorganization. Second, and perhaps more importantly, the court demonstrated a willingness to protect the interests of impaired creditors beyond the purview of the absolute-priority rule through mandated competition. Indeed, the court noted that “[c]ompetition helps prevent the funneling of value from lenders to insiders, no mater 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.”

Because lower courts have not uniformly held that competition is necessary in such situations, Castleton is a step in the right direction for creditors. Commercial lenders throughout the country should be on the watch to see if and when courts in their circuit will follow suit.