For several years, one of the most controversial issues in bankruptcy law has been a Chapter 11 debtor's prior equity holders ability to retain an equity interest in the reorganized entity. The right to retain such an interest in exchange for a new capital infusion into the debtor has been hard-fought in the context of plan confirmation hearings. Secured lenders and other creditors objecting to Chapter 11 reorganization plans have argued with varying degrees of success that permitting old equity holders to retain anything while their own claims are only partially paid, if at all, violates a basic Bankruptcy Code rule requiring that any class of claims or interest be paid in full before any class with lower priority receive anything through a reorganization plan. The ability of prior equity holders to remain in control of a reorganized debtor has also been of significant interest to parties attempting to gain an interest in the reorganized debtor by means such as buying existing creditors' claims.
New Value Exception
On May 3, 1999, the Supreme Court issued its decision in Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership, which was widely expected to resolve a split among circuit courts of appeal regarding the viability of the Chapter 11 plan confirmation principle now commonly known as the "new value exception" or "new value corollary" to the Bankruptcy Code's "absolute priority rule." 11 U.S.C. ' 1129(b)(2)(B)(ii). While the LaSalle decision confirmed that the "new value corollary" may exist, it appears likely to generate even further debate as to its implementation.
In order to understand the significance of the new value doctrine, it is useful to understand the basic mechanics of a debtor's exclusive right to propose a Chapter 11 plan, as well as the more complex mechanics of the plan confirmation process. The Bankruptcy Code currently provides a debtor with the exclusive right to file a Chapter 11 plan for 120 days after the commencement of the case, subject to reduction or extension under certain compelling circumstances. Debtors are routinely granted extensions of "exclusivity," while terminations of exclusivity are less liberally granted. In general, the debtor's exclusive right to file a plan is significant because it effectively affords the debtor a preferential opportunity to steer the plan negotiation process and potentially set the terms of the reorganization. As long as the debtor remains under the control of existing equity holders, this exclusive right may enable the debtor to devise a plan that treats existing equity holders more favorably than some other would-be plan proponents might. While the plan confirmation process is intended to ensure that the plan does not favor existing equity holders over creditors, the rules historically have been applied with sufficient flexibility to undermine the creditor protections. Consequently, although valid reasons exist for providing a debtor the first opportunity to propose a plan, this opportunity carries with it a risk of abuse at the expense of creditors.
Cram Down and Absolute Priority
The general creditor acceptance requirement established in ' 1129(a), the Bankruptcy Code's plan confirmation statute, is subject to the so-called "cram down" exception contained in ' 1129(b). Section 1129(b) provides an alternative plan confirmation procedure in the event a class of creditors objects to a proposed plan. Primary among the conditions for cramdown is the requirement that a plan be "fair and equitable" with respect to all objecting classes. Under the Code, a plan is not considered fair and equitable with respect to any objecting class of creditors if it violates the "absolute priority rule" by enabling a junior class of creditors or interests to "receive or retain . . . on account of such junior claim . . . any property." 11 U.S.C. ' 1129(b)(2)(B)(ii). In essence, the absolute priority rule prohibits any class from receiving anything of value under a proposed plan unless and until all senior classes of claims and interests have been paid in full. This prohibition has been applied in certain jurisdictions to preclude a debtor's former equity holders from retaining any equity interest in the reorganized entity through a proposed plan which does not first pay all senior creditors in full, notwithstanding a proposed capital contribution by those equity holders.
Other jurisdictions, however, have carved out a "new value exception" to the absolute priority rule which permits prior equity holders to retain an interest in the debtor if they contribute new capital in money or equivalent value. The existence of this new value exception has been premised on the statute's phrase "on account of" as limiting the absolute priority rule to only those circumstances in which prior equity holders receive a new interest as compensation for their old interest. Thus, the new value exception is intended to permit an infusion of capital by existing equity holders but does not allow them to acquire new interests in the reorganized entity on account of their old equity investment. In the Fourth Circuit, the availability of the new value exception has been dubious since the decision in In re Bryson Properties, XVIII, 961 F.2d 496, 504 (4th Cir. 1992).
The problem associated with a debtor's exclusive right to propose a plan described above is that other parties are prevented from proposing alternative plans that may place a different value on the "equity" of the reorganized entity. For example, the debtor may propose a "new value" plan that capitalizes the debtor at a relatively modest level based on the existing equity holders' ability to contribute funds. In contrast, a group of creditors might propose a plan that provides a higher amount of capital from creditors and third parties. Alternatively, a group of creditors might propose to "purchase" the "equity" of the debtor by offering to pay all other creditors in full in order to gain control of the debtor's assets. While the debtor's plan may manage to satisfy the minimal requirements of ' 1129, it may nevertheless be a less attractive option compared with the creditors' plan.
The Supreme Court's Review
In LaSalle, the Supreme Court performed an exhaustive review of the legislative history behind ' 1129(b), and found that the history offered "nothing to disparage the possibility apparent in the statutory text that the absolute priority rule now on the books . . . may carry a new value corollary." Accordingly, the Court concluded that the phrase "on account of such junior claim" could arguably imply a new value corollary. However, a debtor's pre-bankruptcy equity holders may not, over the objection of senior creditors, avoid the prohibition of the absolute priority rule by contributing new capital in order to receive an interest in the reorganized entity when the opportunity to do so is given exclusively to those prior equity holders. A "causal relationship" sufficient to trigger the absolute priority rule exists wherever the prior equity holder's interest in the reorganized entity comes at a price less than someone else would have paid for that same equity interest. As a result, plans providing junior interest holders with an exclusive opportunity to receive equity in the reorganized debtor without the benefit of submitting the opportunity to market valuation are per se unconfirmable. Thus, the plan at issue in LaSalle was doomed by its provision for vesting equity in the reorganized entity in the debtor's partners without offering the same opportunity to anyone else or allowing competing plans of reorganization.
Beyond this relatively straightforward prohibition against exclusive investment opportunity, the Court proceeded in surprisingly extended dicta to discuss the nature and extent of evidence necessary to test the "new value" price to be paid by old equity against the market. The Court commented that "top dollar" must be paid and that the best way to determine value is by "exposure to a market," but reiterated that it has not decided "[w]hether 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." Thus, while the LaSalle decision establishes a clear rule as to what plans are per se unconfirmable, it raises puzzling new questions as to how confirmability can successfully be demonstrated. Interpretation of the LaSalle decision will likely provide fodder for further debate among jurisdictions in years to come and perhaps elicit another Supreme Court opinion on the subject. In the meantime, lenders opposing plans of reorganization and parties attempting to gain an interest in the reorganized entity should carefully consider the implications of the LaSalle opinion.