Can an equity investor who directs an insider to contribute "new value" to a debtor under a plan of reorganization, so as to retain his interest in the company, avoid an express market test for that new equity? The answer to that question is a resounding "no," according to Chief Judge Easterbrook of the Seventh Circuit Court of Appeals in In re Castleton Plaza, LP, Case No. 12 Civ. 2639, 2013 WL 537269 (7th Cir. Feb. 14, 2013). That decision addressed a question of first impression among the federal courts of appeal: whether the Supreme Court's seminal holding in Bank of America Nat'l Trust & Savings Ass'n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999), which held that an old (pre-bankruptcy) equity investor seeking to retain an ownership interest in the debtor based on a contribution of new value must submit to a competitive process or market test, also applied when an insider non-equity holder provided the new investment. The Seventh Circuit's decision provides guidance on an issue on which bankruptcy courts have diverged. Castleton also confirms the continuing vigor of the "absolute-priority rule" set forth in section 1129(b)(2)(B)(ii) of the Bankruptcy Code, which provides that a debtor's equity holders may not retain their interests under a plan of reorganization unless and until all creditors are paid in full.
THE ISSUES IN CASTLETON PLAZA
The relevant facts were undisputed. George Broadbent owned 100 percent of the equity in the debtor, Castleton Plaza ("Castleton" or the "Debtor"), which operated a shopping center in Indianapolis, Indiana. Broadbent was also CEO of a company that managed Castleton, The Broadbent Company, Inc. ("Broadbent Company"), for which he earned a $500,000 salary. EL-SNPR Note Holdings, Castleton's only secured creditor, held a $10 million note secured by the Debtor's interest in the shopping center, including, among other things, rents. Castleton failed to pay the note when it matured and commenced a chapter 11 bankruptcy proceeding shortly thereafter. During its exclusive period to file a plan of reorganization, Castleton proposed a plan of reorganization that would write down the note's balance by almost $2 million, cut its rate of interest from 8.37 to 6.25 percent, extend the loan for 30 years and eliminate the note's additional security features. In addition, unsecured creditors would be paid 15 percent on their allowed claims and the management contract between Castleton and Broadbent Company would be assumed, including George's $500,000 salary. The plan also proposed that 100 percent of Castleton's new equity would go to Mary Clare Broadbent, George's wife, on account of an investment of $375,000 in the reorganized company. EL-SNPR objected, arguing that Castleton's assets had been undervalued, and offered to pay $600,000 for the new equity, as well as paying the unsecured creditors in full. EL-SNPR also asked the bankruptcy court to require that Mary Clare Broadbent's offer to purchase the new equity be subject to a competitive auction process.
The bankruptcy court denied the request and approved the plan as proposed. According to the bankruptcy court, competition wasn't necessary because section 1129(b)(2)(B)(ii) of the Bankruptcy Code deals only with "the holder of any claim [or interest]" that is junior to the impaired creditor's claim, and Mary Clare Broadbent did not hold an interest in the debtor. EL-SNPR appealed this holding and the bankruptcy judge certified the question for direct appeal to the Seventh Circuit under 28 U.S.C. § 158(d)(2)(A), which the Circuit Court accepted.
THE SEVENTH CIRCUIT'S DECISION
The Seventh Circuit reversed the bankruptcy court's decision. In an opinion authored by Chief Judge Easterbrook, the court ruled that Castleton's plan of reorganization should be submitted to competitive bidding under the U.S. Supreme Court's 203 North LaSalle decision. The court reasoned that a "new-value" plan that channeled new equity to an insider of an old equity investor, here the investor's spouse, would potentially circumvent the absolute-priority rule just as effectively as conferring new equity on the investor himself. Id. In this case, the Court explained, George Broadbent would receive value from his wife's investment in reorganized Castleton, retention of his $500,000 salary as CEO of Broadbent Company and an increase in his family's wealth due to Mary Clare Broadbent's new ownership of Castleton. Id.
The court also analogized to tax law, noting that the indirect benefits to be received by George Broadbent would be considered as income under the Internal Revenue Code and thus would qualify as "value" for purposes of the absolute-priority rule. Specifically, under the plan confirmed by the bankruptcy court, George Broadbent received value on account of his old equity interest because it permitted him to control the Debtor and thus propose a plan of reorganization that provided a valuable opportunity for his wife to purchase the Debtor on the cheap. The court held that this outcome could not be squared with 203 North LaSalle's competition requirement, which "helps prevent the funneling of value from lenders to insiders . . . ." The court recognized that the need for competitive bidding was particularly compelling where, as here, the secured lender believed the debtor's assets were undervalued and its secured claim was being substantially impaired.
The Seventh Circuit's decision in Castleton Plaza helps clarify the application of 203 North LaSalle to new investments by insiders, an issue on which bankruptcy courts have differed. It also clarifies a question left open by LaSalle: whether LaSalle's directive that a new-value plan needs to be market-tested requires an auction, and not just expert testimony as to value or a showing that attempts to market the debtor were futile or couldn't top what insiders were offering. Castleton makes clear that competitive bidding is required, at least in those instances where the new investment is offered by an insider of the old equity investor. As such, the decision is of interest generally to secured lenders and particularly to creditors and owners in single-asset real estate cases, where new-value plans are common.
Castleton also has broader implications for a wide range of reorganization cases. Its endorsement of competitive bidding joins ranks with the U.S. Supreme Court, which recently ruled in RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S.Ct. 2065 (2012) that secured creditors may not be precluded from credit bidding their claim under a plan of reorganization in an auction for the debtor's assets.
In addition, the Castleton decision follows a trend exemplified by the Second Circuit and Third Circuit, which have reaffirmed the vigor of the absolute-priority rule in the context of so-called "gifting plans," in which a secured creditor consents to its distribution but then directs that the debtor pay dividends on claims of, for example, trade and/or equity but not unsecured bondholders. In In re Armstrong World Industries, Inc., 432 F.3d 507 (3d Cir. 2005) and In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011), the Circuit Courts ruled that gifting plans violate the absolute-priority rule, because they permit old equity to receive shares in the reorganized company even though unsecured claimants are not made whole. See Armstrong, 432 F.3d at 514; DBSD, 634 F.3d at 100-101. The Armstrong and DBSD cases make clear that courts will enforce the substance of the absolute-priority rule, which is designed to serve creditors, over attempts to evade it through insider equity purchases or "gifts" from secured lenders.
Although the terms of Castleton's plan were fairly outrageous and a transparent attempt to circumvent the absolute-priority rule, the Castleton decision strengthens the observation gleaned from Armstrong and DBSD that courts will not hesitate to reign in creatively-structured plans when they threaten the vitality of the absolute-priority rule. The court's reference to broad tax principles likewise underscores the court's reasoning that if an equity holder receives any benefit, whether direct or indirect, on account of that interest under a plan (the Internal Revenue Code here defining what should be considered a benefit), it runs afoul of the absolute-priority rule. By reinforcing the absolute-priority rule in the face of creative lawyering, the Castleton decision is of interest to all stakeholders in corporate chapter 11 reorganization cases.
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