As real estate markets continue to rebound, owners of single asset real estate[1] properties are increasingly incentivized to devise bankruptcy strategies that allow them to keep ownership of their properties. In situations where the property at issue is underwater relative to its secured debt, an owner may nonetheless wish to keep control of the property in hopes that its value will rise in the future to an amount that exceeds the indebtedness. However, in order to do so, one of the gating items the owner must overcome is the absolute priority rule.[2]
Recently, in Castleton[3], the Seventh Circuit Court of Appeals issued a ruling that provides much needed clarity to practitioners confronted with the application of the absolute priority rule and sales of equity to insiders.
The absolute priority rule ensures that the statutory priority scheme established by the Bankruptcy Code (and hundreds of years of open-market financing) is adhered to and requires that unsecured debt be paid in full before the equity may retain any interest in the debtor. However, courts historically recognized an exception to the absolute priority rule known as the "new value corollary,"[4] which provides that if existing equity invests “new value” into the enterprise, it may retain its equity, despite the fact that holders of claims senior to equity may not be paid in full. In Bank of Am. Nat. Trust and Sav. Ass'n v. 203 N. LaSalle St. P'ship[5], the Supreme Court held that new value plans that provide existing equity holders "with exclusive opportunities free from competition and without benefit of market valuation" to own the equity of the reorganized entity violate the absolute priority rule. However, the Supreme Court stopped short of setting bright-line rules for satisfying the competition requirement, to wit: "Whether a market test would require an opportunity to offer competing plans or would be satisfied by a right to bid for the same interest sought by old equity is a question we do not decide here."[6]
One significant question that has emerged post-LaSalle is whether the "market test" applies to a debtor's sale of equity to an insider. Not surprisingly, lower level courts around the country have answered that question in a non-uniform matter. On the debtor-oriented side of the table, applying a strictly literal reading of section 1129(b)(2)(B)(ii), some courts have found that a nonmarket tested sale to an insider does not violate the absolute priority rule, while more creditor-friendly courts have looked at the totality of the circumstances surrounding the sale and concluded in some instances that such a sale does violate the absolute priority rule. In the first circuit-level decision on the issue, the Seventh Circuit Court of Appeals ruled in Castleton that insider sales to equity must be market tested.
Lower Courts Disagree as to the Application of LaSalle to Sales to Insiders
Two lower court cases demonstrate the clear split of authority on whether LaSalle applies to insider sales.
Not long after LaSalle was decided by the Supreme Court, the issue of whether a sale to an insider needed to be market tested was front and center in Beal Bank, S.S.B. v. Water's Edge Ltd. P'ship.[7] In this case, the debtor limited partnership owned an apartment complex that could not generate sufficient income to service the lender's $29.5 million mortgage. The debtor proposed a plan of reorganization predicated on the sale, sans any market test, of all of the equity in the reorganized debtor in exchange for an infusion of new capital by the son-in-law of the partner that held a 99.5 percent interest in the debtor.
The lender objected to confirmation by arguing (i) an insider sale of ownership in a single-asset debtor without a market test was equivalent to a sale of its collateral, entitling it to credit-bid its secured claim; and (ii) the plan violated the absolute priority rule by permitting the original partner to preserve his interest via the insider sale. The court rejected both arguments and held that the sale of equity did not frustrate the bank's right to credit-bid and refused to accept that the insider was acting as a "straw man" for the original partner without further proof. Thus, the court permitted the sale to the insider.
However, a few months after the decision in Beal Bank was rendered, the Delaware bankruptcy court was confronted with a similar issue and similar facts in In re Global Ocean Carriers Ltd.[8] Here, the plan proposed to sell all of the stock in the reorganized debtor to the majority shareholder's daughter in return for a $10 million capital contribution. Unlike the court in Beal Bank, the Delaware court held that the plan violated the absolute priority rule because the debtor's largest shareholder retained the exclusive right to determine who would be the debtor's owner, and at what price, without the benefit of a public auction or competing plan.
Notably, the court disagreed with the Beal Bank court's focus on the identity of the insider and whether he/she was acting as a straw party to the old equity holders. Instead, the court focused on the exclusive right to control to whom the sale of equity is being made and found that the right to control must be market-tested. Based upon a review of other cases on point, it is apparent that courts are split as to whether equity owners of a debtor can avoid application of the absolute priority rule and continue to control the debtor post-bankruptcy through transfers to insiders.[9]
The Seventh Circuit Expressly Applies LaSalle to an Insider in In re Castleton Plaza
As the first and only circuit to do so, the Seventh Circuit expressed its view on the subject by extending the LaSalle competition rule to apply to not just equity holders seeking to hold onto the equity themselves, but also to "new value" contributions by insiders of the debtor.[10] The Seventh Circuit held that a new value plan granting equity to insiders in exchange for a contribution of new capital, but leaving creditors impaired, cannot be confirmed unless the insider's contribution is subjected to a competitive process.
Castleton Plaza is a shopping centered owned by the debtor, an Indiana limited partnership. George Broadbent owned 98 percent of the debtor's equity directly and 2 percent indirectly. Unable to pay installment payments, the debtor filed a voluntary petition for bankruptcy relief under Chapter 11. The debtor proposed a plan of reorganization which failed to pay creditors in full and provided for Mr. Broadbent's wife to receive 100 percent of the equity in the reorganized debtor in exchange for a $375,000 "new value" investment. In addition, the wife owned the management company that employed Mr. Broadbent to run the shopping center.
The bankruptcy court of the Southern District of Indiana confirmed the debtor’s plan and rejected the underwater secured creditor's argument that there should be an open auction for the equity. The bankruptcy court's ruling was seemingly based upon the fact that the wife contributed her own money and did not hold previously hold an equity interest in the debtor entity.
In a direct appeal to the Seventh Circuit[11], the appellate court reversed the bankruptcy court, holding that an equity investor cannot evade the absolute priority rule by arranging for new value to be contributed by an insider. Therefore the case was remanded with directions to open the proposed plan for competitive bidding. In a strongly worded opinion, Judge Easterbrook noted that confirmation of the debtor's plan would render meaningless the U.S. Supreme Court's decision in LaSalle and emphasized that competition is the best way to determine if maximum value is being received for the new equity.
Focusing on the particular facts of the debtor's plan, the Seventh Circuit specified the three ways in which Broadbent retained substantial benefits by transferring equity to his wife: (i) Broadbent continued to receive an annual salary of $500,000 as the CEO of the property management company owned by his wife, which would continue to manage the shopping center if the couple retained control of the debtor and its sole property; (ii) the couple's collective wealth would increase; and (iii) Broadbent retained the valuable right to exercise the power of appointment in favor of his wife as purchaser of his equity in the borrower. The retention of these benefits violated the absolute priority rule.
Impact of Castleton
Without question, the Castleton decision is a pro-creditor outcome that protects unpaid creditors by ensuring that an equity holder cannot maintain control of the debtor indirectly after confirmation of a plan without first permitting an auction of that equity with competitive bidding. A competent marketing process for the equity that includes competitive bidding will likely maximize the market value received for the property interest and thereby result in greater distributions to creditors.
By its determination in Castleton and its reliance, in dicta, on the Supreme Court's ruling in RadLax[12], the Seventh Circuit continued its trend of leveling the playing field for secured creditors and allowing them to avail themselves of statutory protections designed to protect the priority scheme.
In the future, creditors unsatisfied with a debtor's plan will likely continue to push for the application of the LaSalle market test requirements to level the playing field with existing equity. Indeed, in situations where existing equity has ostensibly constructed its plan to maintain its control of the reorganized debtor, Castleton is a sharp sword available to creditors to contest such a structure. As RadLax and Castleton show us, the chess game between debtors and creditors will continue into the future.
Perhaps the next line of litigation on the application of LaSalle and Castleton will be a debate over when and whether one or both of the two market test options (competing bids or competing plans) should be used. Even upon selecting an appropriate market test, courts may diverge as to how to best arrange for and process the competing bids or plans. Lastly, courts likely will vary in the weight of factors they consider in choosing between competing bids or plans.
--By Jay M. Sakalo and Rena Kelley, Bilzin Sumberg Baena Price & Axelrod LLP
Jay Sakalo is a partner in the restructuring & bankruptcy group of Bilzin Sumberg Baena Price & Axelrod in the firm's Miami office and handles all facets of bankruptcy reorganizations and bankruptcy litigation. He has served as counsel to numerous debtors, creditors committees and purchasers of assets in complex Chapter 11 cases. He has represented committees and creditors in some of the largest bankruptcies filed in the country, including W.R. Grace, U.S. Gypsum and K-Mart.
Rena Kelley is an associate at the firm's Miami office.
The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] See 11 U.S.C. § 101(51)(B)
[2] See 11 U.S.C. § 1129(b)(2)(B)(ii).
[3] In re Castleton Plaza LP, No. 12-2639, 2013 WL 537269, at *1 (7th Cir., Feb. 14, 2013).
[4] Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988); Case v. Los Angeles Lumber Prod. Co., 308 U.S. 106, 121 (1939); In re Bonner Mall P'ship, 2 F.3d 899 (9th Cir. 1993).
[5] 526 U.S. 434, 458 (1999).
[6] Id.
[7] 248 B.R. 668 (D. Mass. 2000).
[8] 251 B.R. 31 (Bankr. D. Del. 2000).
[9] See, e.g., In re Greenwood Point LP, 445 BR 885 (Bankr. S.D. Ind. 2011); Troy Sav. Bank v. Travelers Motor Inn Inc., 215 B.R. 485 (N.D.N.Y.1997); In re Century Glove Inc., CA No. 90-400-SLR, 1993 WL 239489, at *1 (D. Del. Feb. 10, 1993).
[10] Castleton, 2013 WL 537269, at *1.
[11] Pursuant to 28 U.S.C. § 158(d)(2)(A)(i)-(iii).
[12] RadLAX Gateway Hotel LLC v. Amalgamated Bank, 132 S. Ct. 2065 (2012).
This article is reprinted with permission from Law360.
