Seventh Circuit Holds That Debtor Cannot Circumvent Bankruptcy's Absolute-Priority Rule

Winthrop & Weinstine, P.A.

Unless creditors accept a debtor's plan of reorganization, bankruptcy law requires the plan to provide for the payment in full of creditors before owners of the debtor receive anything on account of their equity interest. This is commonly known as the "absolute-priority" rule. In at least some jurisdictions, equity holders can receive or retain something of value if they contribute "new value" to the bankruptcy estate. This is commonly known as the new-value exception to the absolute-priority rule. But even in jurisdictions that recognize the new-value exception, the United States Supreme Court has held (in 203 North LaSalle Street Partnership) that pre-bankruptcy equity holders cannot receive or retain an ownership interest unless that interest is exposed to competitive market forces where other parties can bid.

In Castleton Plaza, a case recently handed down by the Seventh Circuit Court of Appeals, a pre-petition equity investor in the debtor attempted to circumvent the absolute-priority rule by causing the debtor to file a plan of reorganization allowing his wife to acquire ownership of the debtor without exposing the ownership interests to competing bids. The Bankruptcy Court held that this maneuver did not violate the absolute-priority rule because the spouse did not own any interest in the debtor before the bankruptcy.

On appeal, the Seventh Circuit Court of Appeals found that the pre-petition investor would receive value from the equity his spouse stood to obtain under the plan. As a result, the Court of Appeals reversed the bankruptcy court's decision and held that the plan violated the absolute-priority rule because it failed to expose the asset to the market and competitive bidding. The Court stated: "[P]lans 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 Plaza is obviously a good case for creditors because it promotes open competitive bidding on bankruptcy assets and prevents debtors and insiders of the debtors from retaining valuable assets unless they either pay creditors in full, obtain creditor consent, or expose the assets to competitive market forces.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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