Friday, February 22, 2013

“New Value” Auctions Extended to Insiders

In Bank of America National Trust and Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999), the Supreme Court held that the absolute priority rule, which provides that equity cannot participate in the reorganization if senior creditors have not been paid in full, could not be circumvented by equity investors contributing “new value” unless other parties were permitted to compete to provide new value.  The theory was that equity could divert the value from, for example, secured creditors, by undervaluing the secured creditor’s interest in the property and obtaining more actual value than the amount of new value they contributed.

In Castleton Plaza LP, the United States Court of Appeals for the Seventh Circuit was confronted with a new value plan that had been confirmed by the Bankruptcy Court where the new value was contributed by an insider relative of old equity, rather than old equity itself.  The Bankruptcy Court had held that such a plan would not be subject to the auction requirements of 203 North LaSalle.

The Seventh Circuit reversed.  It held that while the insider was not the holder of a claim, the bidding rule established by LaSalle was designed to “curtail evasion of the absolute priority rule.”  The Seventh Circuit held that the insider investment, here by the wife of the principal, had the same effect of evading the absolute priority rule and diverting value away from the secured creditor and to the insider.  The Court also noted that the equity holder would benefit, indirectly at least, by the increase in family wealth and his position as CEO of the management company, and concluded that the right to propose a plan designating who could and could not contribute new value was akin to a power of appointment which, under the tax laws, would be treated as income to the holder of the power of appointment.  Therefore, the equity holder who had the right to designate under that plan received value on account of his old equity interest.

This is the first Circuit Court decision that has ruled on this important issue, and the bankruptcy courts are split.  The decision of the Seventh Circuit is true to the spirit of 203 North LaSalle that there needs to be a market test through bidding to determine the economic proportionality of the proposed new value and whether same truly represents the true value of the interest in the property.  Permitting the important principles of 203 North LaSalle to be circumvented by utilizing a relative of the equity holder is, in fact, a subterfuge to avoid the impact of the absolute priority rule, requiring creditors be paid in full before equity can participate or gain value from a plan.

Karen Lee ("Kitt") Turner
Eckert Seamans Cherin & Mellott, LLC
Philadelphia, Pennsylvania

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