Seventh Circuit holds that new equity in a Chapter 11 debtor must be auctioned…and that a creditor may credit bid.

In a Chapter 11 bankruptcy, if the debtor’s owners want to continue to own the debtor after confirmation, they must (1) pay the unsecured creditors in full; or (2) get the consent of the unsecured creditors; or (3) contribute sufficient new value in exchange for their interests in the reorganized debtor. The third option is often called the “new value corollary to the absolute priority rule”—a fancy way to say that equity has to pay something to keep the debtor before the court will force the debtor’s unsecured creditors to take a haircut. But how do we know how much new value is enough?

The Seventh Circuit recently held that only competitive bidding can tell us if the price paid for the new equity is sufficient. In re Castleton Plaza, LP, 2013 WL 537269 (7th Cir. 2013). In Castleton, the plan proposed to give 100% of the reorganized debtor to the former owner’s wife in exchange for a contribution of cash. Unsecured would receive only a 15% distribution. The debtor’s lender believed that the court had undervalued its collateral and offered to pay significantly more for the equity than the wife offered and also proposed to pay unsecureds in full. The debtor rejected the proposal, and the lender asked the court to require the debtor to put the new equity up for auction. The bankruptcy court denied the request and confirmed the plan as proposed.

The Seventh Circuit reversed, holding that the new equity must be subject to competitive bidding. The court first rejected the debtor’s argument that the absolute priority rule did not apply because the wife was getting the new equity. The court concluded that a plan that proposes to sell new equity to an insider is the same as a plan that proposes that old equity keep its ownership. The court then held that only competitive bidding could determine whether the amount contributed would be sufficient to satisfy the absolute priority corollary and enable a plan to be confirmed over the objection of unsecured creditors.

Thus, if the old owners of a Chapter 11 debtor (or their spouses or other close relatives) want to own the reorganized debtor but don’t want to pay unsecured creditors in full, then they must put the ownership in the debtor up for competitive bidding.

Another interesting part of the Seventh Circuit’s holding concerns the ability for a lender to credit bid at a sale of the new equity. The court held that in this competition, “creditors can bid the value of their loans.” The court did not explain this aspect of its decision, except to cite a Supreme Court decision dealing with a secured creditor’s right to credit bid in a § 363 sale of its collateral. The Seventh Circuit, it seems, would extend the right credit bid to unsecured creditors in an auction of the sale of the debtor’s equity. We will have to see if this aspect gets much traction with other courts.