The U.S. Supreme Court has armed senior creditors with a new weapon against debtors who default, file for relief under Chapter 11 and then attempt to unilaterally impose "cramdown" reorganization plans on their creditors. In a much anticipated decision, the U.S. Supreme Court severely limited the use of the new-value exception to the absolute-priority rule.
In Bank of America National Trust 203 North Lasalle Street Partnership, 119 S.Ct. 1411 (1999), the Court considered whether a debtor's prebankruptcy equity holders may be given the exclusive opportunity to contribute new capital and receive ownership interests in the reorganized entity, over the objections of a senior class of impaired creditors. The Court held plans that provide junior interest holders with the exclusive opportunity to own the reorganized entity -- free from competition and without the benefit of market valuation -- fail to satisfy the "absolute priority rule" under the Bankruptcy Code. Thus, debtors cannot infuse new capital in exchange for sole equity ownership in the reorganized entity without that same opportunity being offered simultaneously to the senior creditors.
The Bankruptcy Plan
Creditor Bank of America National Trust's $93 million loan to the debtor, 203 North Lasalle Street Partnership, was secured by a 15-floor office building in downtown Chicago. When the debtor defaulted and the bank began foreclosure proceedings in state court, the debtor filed a voluntary petition for relief under Chapter 11 -- which had the immediate effect of staying the foreclosure proceedings. Because the value of the building was less than the balance due, the bank elected to divide its undersecured claim into secured and unsecured deficiency claims. Because the building was valued at $54.5 million, the unsecured deficiency was $38.5 million. While the debtor's plan called for the $54.5 million secured claim to be paid in full to the creditor over 7 to 10 years, the creditor would only receive 16 percent of the $38.5 million unsecured claim. However, in exchange for a contribution of $6.125 million in new capital over the course of five years, the debtor's equity partners would receive sole ownership of the reorganized debtor.
The Court held that this plan violated the "absolute priority" rule of Bankruptcy Code § 1129(b)(2)(B)(ii), which states that "the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property." Although the new value exception is not explicitly mentioned in the Code, the Court discussed lower court decisions that found the exception part of the "on account of" language in § 1129. The court considered various interpretations of the "on account of" language, ultimately deciding it meant either: (1) that junior claim holders could not retain their interests under a reorganization plan "because of" their status as junior claim holders; or (2) that reorganization plans had to reconcile the two recognized policies of Chapter 11, namely "preserving going concerns" and "maximizing property available to satisfy creditors." Ultimately, the Court did not decide between these two interpretations, instead ruling that the reorganization plan at issue failed to satisfy both. In other words, the Court viewed the "exclusive" opportunity to infuse new capital and retain the security as a property right that the junior equity holders possessed only "on account of" their status and thus are required to share with senior creditors.
What does this mean for senior lenders? The concurrence among legal commentators is that the decision is likely to result in a shift in bargaining leverage between borrowers and lenders. In particular, a borrower's threat of a bankruptcy filing may not carry nearly the same weight now that confirmation of a plan "cramming down" a secured lender's claim is unlikely unless creditors are given an opportunity to fairly compete for ownership of the reorganized debtor.
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