On May 3, 1999, the United States Supreme Court delivered its long awaited decision Bank of America v. 203 North LaSalle Street Partnership, 126 F.3d 955 (1999), and in doing so created some serious impediments to the confirmation of so-called "new value" plans of reorganization in Chapter 11 cases. The decision, written by Justice David Souter, was approved 8-1, with Justices Thomas and Scalia concurring and Justice Stevens dissenting.
Background
The case arose out of a loan made by Bank of America to a real estate limited partnership, 203 North La Salle Street Partnership. The loan was secured by the debtor's interest in an office building located in downtown Chicago. The debtor defaulted on the loan and filed a Chapter 11 petition to stave off the Bank's foreclosure.
The Bank's claim was severely underwater - the property was worth $54.5 million, while the Bank's indebtedness was over $90 million. As is typical in single-asset real estate cases, the other claims were minimal. The property owner proposed a Chapter 11 plan of reorganization in which the existing limited partners would contribute $3 million in new value immediately, plus $625,000 per year for five years. Confirmation of this plan would enable the existing partners to avoid an approximately $20 million tax liability that would result from the Bank's foreclosure.
The Bank objected to confirmation, but the the Bankruptcy Court confirmed the plan over the Bank's objection. The District Court and Seventh Circuit both affirmed, agreeing that the so-called "new value" exception to the Bankruptcy Code's absolute priority rule was alive and well. The Supreme Court, noting a conflict between the Ninth and Seventh Circuits, on the one hand, and the Second and Fourth Circuits, on the other, granted review.
Analysis of the Supreme Court's Opinion
During real estate downturns, owners of real property commonly have proposed plans of reorganization in which they seek to retain ownership, limit the claims of secured creditors to the current value property and pay a fraction of any unsecured deficiency claim owed to the real estate lender. The "new value" feature of such plan, seemingly authorized by the Supreme Court decision of Case v. Los Angeles Lumber Products Co., 308 U.S. 106, (1939), contemplates that the existing owners will invest new money, usually modest in comparison to the unsecured deficiency claim of the secured creditor, in order to make payments under the plan and fund the ongoing financial needs of the debtor after reorganization. Although new value plans have primarily been proposed in the single asset real estate scenario, the issue also arises in any context in which the current owners (generally the principal shareholders of a corporate debtor or the partners in a partnership) of a Chapter 11 debtor wish to retain control of the debtor following confirmation of a reorganization plan.
Secured creditors have frequently objected to new value plans, contending that they violated the bankruptcy rule of absolute priority. The absolute priority rule, which appears in 11 U.S.C. ' 1129(b)(2)(B)(ii), provides that holders of equity interests may not receive anything "on account of" their interests until all senior classes (including the unsecured deficiency claim) have been paid in full. Secured creditors have argued that the "new value" exception to the absolute priority rule, ostensibly found in the Los Angeles Lumber case, did not survive the enactment of the Bankruptcy Code in 1979.
The Supreme Court has several times ducked this issue, and in 203 North LaSalle purports to duck it again, stating that "[w]e do not decide whether the statute includes a new value corollary or exception." Having said that, however, the Court goes on to hold that, in any event, holders of old equity may not obtain or retain anything of value under a plan on "account of" its existing interest in the property. The Court interpreted "on account of" to have the plain meaning "because of," and found that the owners in 203 North LaSalle gained an unfair advantage (in this case, as a result of their exclusive right to file a plan of reorganization) solely because of their existing interest in the property.
The Court specifically ruled that the flaw in the 203 North LaSalle plan was its "provision for vesting equity in the reorganized business in the Debtor's partners without extending an opportunity to anyone else either to compete for that equity or propose a competing plan." In so deciding, the Court also dismissed the Bankruptcy Court's determination of the fairness of the proposed new value contribution, holding that the only way to value the equity holders' right to continued participation in the reorganized debtor was to expose the ownership opportunity to the open market. The Court expressly declined to decide whether the absolute priority rule would prohibit the holders of old equity from even bidding on the property in a market disposition.
Practical Significance of the Opinion
Although the opinion seems at first to be limited by its unwillingness to resolve the issue of whether holders of old equity may participate at all in the disposition of the property, in fact the opinion would appear to preclude old equity from obtaining any sort of advantage as a result of its "inside track." For example, the 203 North La Salle decision might well prohibit holders of old equity from obtaining a break-up fee as the stalking horse bidder in an auction sale, since the existence of the break-up fee might tend to chill bidding. Likewise, the ruling draws into question the viability of bonuses, special contracts or other sorts of compensation offered by a potential buyer to the existing management of an operating company, if such compensation is only being made available "on account of" the existing equity interests.
In the future, it appears that existing equity holders will have offer the debtor's property for sale on the open market as a prerequisite to obtaining court approval of for old equity to retain ownership on any basis. This requirement may create substantial new opportunities to potential investors who have heretofore been shut out out of the bidding for property by old equity bent upon retaining ownership under a new value plan. The future of the "new value" litigation is now likely to turn away from issues of whether the proposed new value is necessary, or fair, and to turn instead to issues of whether the property was effectively marketed to other potential acquirors in a commercially reasonable manner.
) 1999 Sheppard, Mullin, Richter & Hampton LLP.
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