First (Post-) Impressions: Insider Distribution Violates Absolute Priority Rule, And Competition Is Essential Element Of NewValue Corollary

Until 2013, no circuit court of appeals had weighed in on the implications of the U.S. Supreme Court's pronouncement in the 203 North LaSalle case that property retained by a junior stakeholder under a cram-down chapter 11 plan in exchange for new value "without benefit of market valuation" violates the "absolute priority rule." See Bank of Amer. Nat'l Trust & Savings Ass'n v. 203 North LaSalle Street P'ship, 526 U.S. 434 (1999), reversing Matter of 203 North LaSalle Street P'ship, 126 F.3d 955 (7th Cir. 1997).

That changed when the Seventh Circuit Court of Appeals recently handed down its ruling in In the Matter of Castleton Plaza, LP, 2013 BL 40570 (7th Cir. Feb. 14, 2012). The court reversed a bankruptcy court ruling that a proposed plan under which an "insider" of the debtor would receive 100 percent of the equity in the reorganized company in exchange for a cash contribution passed muster under the absolute priority rule despite less than full payment of senior creditors. As a matter of first impression, the Seventh Circuit ruled that: (i) a distribution under the plan of new equity to the insider (the sole former shareholder's spouse) conferred a benefit on the former shareholder; and (ii) the sufficiency of the "new value" proffered by the insider had not been tested by competition and thus violated the absolute priority rule.

Cram-Down and the "Fair and Equitable" Requirement

If a class of creditors or shareholders votes to reject a chapter 11 plan, it can be confirmed only if the plan satisfies the "cram-down" requirements of section 1129(b) of the Bankruptcy Code. Among those requirements is the mandate that a plan be "fair and equitable" with respect to dissenting classes of creditors and shareholders.

Section 1129(b)(2)(B) of the Bankruptcy Code provides that a plan is "fair and equitable" with respect to a dissenting impaired class of unsecured claims if the creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, in cases not involving an individual debtor, if no creditor of lesser priority, or no equity holder, receives or retains any distribution under the plan "on account of" its junior claim or interest. This requirement is sometimes referred to as the "absolute priority rule."

Three principal areas of controversy have arisen concerning the absolute priority rule. The first concerns the legitimacy, as a strategy to broker plan confirmation, of senior-class "gifting" under a chapter 11 plan to a junior class of creditors in cases where an intervening class is not being paid in full. The genesis of the second is 2005 amendments to the Bankruptcy Code that ignited a dispute as to whether the absolute priority rule continues to apply in individual chapter 11 cases. The third involves what is commonly referred to as the "new value" exception or corollary to the absolute priority rule. The Castleton Plaza decision focuses on the new value debate.

History of the Absolute Priority Rule

The U.S. Supreme Court first formally articulated the absolute priority rule, originally referred to as the "fixed principle," in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), a case involving the equity receivership of a railroad. According to this precept, stockholders could not receive any distribution in a reorganization case unless creditor claims were first paid in full. The Supreme Court continued to apply this principle in equity-receivership cases throughout the early 20th century, emphasizing that it should be strictly applied.

In 1934, Congress amended the former Bankruptcy Act to introduce the words "fair and equitable" to the bankruptcy lexicon. Section 77B(f) of the Act provided that a plan of reorganization could be confirmed only if the bankruptcy judge was satisfied that the plan was "fair and equitable and does not discriminate unfairly in favor of any class of creditors or stockholders, and is feasible."

The provenance of this restriction was the "fixed principle." As later expressed by the Supreme Court in 203 North LaSalle, "The reason for such a limitation was the danger inherent in any reorganization plan proposed by a debtor, then and now, that the plan will simply...