In a decision issued yesterday, the 7th Circuit Court of Appeals held that insiders can't be given a special opportunity to invest in a bankrupt debtor under the guise of contributing "new value" unless the debtor makes the same investment opportunity available to other potential investors.
The absolute priority rule ordinarily prevents a Chapter 11 debtor from distributing any money or property to equity unless all creditors have been paid in full. Equity investors will sometimes try to sidestep that rule by contributing new value to the debtor as it emerges from bankruptcy. The theory is that the investors are receiving a distribution from the debtor in exchange for their new contribution, not on account of their old equity interests, and so there is no violation of the absolute priority rule.
In In re Castleton Plaza, LP, the 7th Circuit agreed that new value plans are permitted under the Bankruptcy Code, at least in theory. The 7th Circuit held, however, that new value plans are subject to an important constraint: "Competition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider."
George Broadbent owns (directly or indirectly) 100 percent of the equity interests in Castleton Plaza, the debtor. Under Castleton's proposed plan of reorganization, Mr. Broadbent's wife was to receive 100 percent of the equity in the reorganized debtor in exchange for a $75,000 "new value" investment. The plan did not propose to pay creditors in full.
One of Castleton's creditors objected to the new value plan and offered to pay up to $600,000 for the debtor's equity. After Ms. Broadbent increased her offer to $375,000, the bankruptcy court confirmed the debtor’s plan and rejected the creditor's argument that there should be an open auction for the equity.
The 7th Circuit reversed the bankruptcy court, with "directions to open the proposed plan of reorganization to competitive bidding." The 7th Circuit dismissed objections that Mr. Broadbent, not his wife, was the existing equity holder. "A new-value plan bestowing equity on an investor's spouse can be just as effective at evading the absolute-priority rule as a new-value plan bestowing equity on the original investor."
The 7th Circuit's decision has at least two important effects on new value plans. First, courts are likely to want to know whether the debtor accepted the "new value" only after a competitive process in which creditors, stakeholders, and other interested parties were given the chance to meet or beat the terms of the deal. Second, courts can use this decision to brush aside technical compliance with the absolute priority rule where it is apparent that existing equity has designed the plan to preserve control over the reorganized debtor.