The United States Bankruptcy code gives certain creditors priority over other creditors, depending on the type or “class” of debt. For example, the Internal Revenue service has priority over general unsecured creditors.1 This means that priority creditors must be paid in full before the general unsecured creditors receive anything. The lowest priority of creditor in a chapter 11 bankruptcy is an equity interest holder, or shareholder. Shareholders receive nothing until all creditors are paid in full. This is called the “absolute priority rule,” and is codified in section 1129(b)(2)(B)(ii) of the Bankruptcy code.2 In many chapter 11 reorganization proceedings, especially involving closely held corporations, the existing shareholders or a close friend or family member called an “insider” propose to contribute a new investment in order to keep their equity interest in the corporation. The U.S. Supreme Court held in Bank of America National Trust and Savings Association v. 203 North La Salle Street Partnership3 that a debtor’s pre-bankruptcy shareholders may not contribute new capital and receive an ownership interest in the reorganized entity over the objection of a senior creditor without giving other creditors or third parties the opportunity to bid on the equity interest. The seventh circuit recently extended this holding In re Castleton Plaza, LP4 by finding that if a creditor objects to a proposed contribution of new value by an insider to receive the equity in a reorganized debtor corporation, the debtor corporation must market the equity to third parties through some bidding procedure.
In the debtor’s plan of reorganization in 203 North La Salle, the debtor the debtor’s former partners before the bankruptcy proposed to contribute $6.125 million in new capital in exchange for their interest in the reorganized debtor. Bank of America, the debtor’s primary secured lender, objected, arguing that a provision in the plan, which provided that the old shareholders were the only ones who could contribute new capital and obtain an interest in the reorganized debtor, was a violation of the absolute priority rule. The supreme court agreed, and after reviewing the statutory and legislative history of section 1129(b)(2)(B)(ii), found that the proposed provision in the plan did violate the absolute priority rule. The Supreme Court found that the equity interest in the reorganized entity must be marketed to potential third party purchasers.
In Castleton, the debtor sought to get around the rule set forth in 203 North La Salle by providing that the equity interest in the reorganized debtor be purchased by the owner’s wife, who was not an equity owner of the pre-bankruptcy entity. Prior to the bankruptcy, the debtor was owned 98% directly by George Broadbent and the other 2% indirectly by George Broadbent. In the plan of reorganization, Broadbent’s wife offered to pay $75,000 in exchange for a 100% equity interest in the reorganized debtor. The seventh circuit, noting that no court of appeals had addressed the issue of whether competition is essential when a plan of reorganization gives an insider an option to purchase equity in exchange for a new value contribution, found that the proposed plan of reorganization violated the absolute priority rule despite the fact that the new equity contribution was coming from a third party and not the former owners directly.
The court reasoned that having the new value contribution come from an equity holder’s spouse is essentially the same as having the contribution come from the equity holder directly. First, the court noted that for many purposes under bankruptcy law, such as the recovery of preferential transfers, an insider is treated the same as an equity investor and that family members are insiders under the definition of an “insider” under section 101(31) of the Bankruptcy code.5 Second, the former equity holder, George Broadbent, would receive value indirectly from the equity that his wife contributed. In this particular instance, one form of value that Broadbent would have received would be the continuation of his salary from the corporation that managed the debtor. Another form of value would be an increase in his family’s total wealth, because in Indiana, which is a community property state, one spouse usually receives at least an indirect benefit from the other spouse’s wealth. In the court’s view, competition was simply essential to assure that the appropriate market rate had been paid for the equity in the reorganized debtor.
The court’s holding is not surprising given the facts of the case; however, the court’s reasoning could have substantial ramifications on future cases. The court’s reasoning opens the door to litigation over several issues, including who qualifies as an “insider,” how to appropriately market the shares, and how creditors may bid on shares.
The Seventh Circuit has previously held that the definition of an “insider” is not limited to those specific categories of entities mentioned in section 101(31) of the Bankruptcy code.6 Rather, the term “insider,” as defined in section 101(31) “also encompasses anyone with ‘a sufficiently close relationship with the debtor that his conduct is made subject to closer scrutiny than those dealing at arm’s length with the debtor.’”7 Thus, an “insider” could be anyone depending on the facts of the case. For example, presume that the previous owner of a reorganized debtor formed a corporation, corporation X, of which he is a 100% owner, and that under the proposed plan of reorganization corporation X had the exclusive right to purchase the equity in the reorganized debtor for $100,000. Under this factual scenario, corporation X is not an insider under the definition of the Bankruptcy code. However, since corporation X is owned 100% by the former owner of the debtor, it is likely that corporation X is also an insider, since the former owner controls corporation X. Further, since the former owner would obtain an economic benefit due to his ownership of corporation X, the court would likely find that the plan provision violates the absolute priority rule. The water becomes even muddier if corporation X were only partly owned by the former owners of the Debtor. However, given the reasoning of the seventh circuit, this would still violate the absolute priority rule since the former owner gained an economic benefit.
Second, it is unclear as to what extent that the equity interest needs to be marketed. Does there need to be an auction? Must one or more advertisements in the local newspaper? Does actual cash have to be paid? A creditor of the corporation may not have to pay cash to obtain an equity interest in the reorganized entity. Interestingly, one case cited by the seventh circuit was RadLax Gateway Hotel, LLC v. Amalgamated Bank, 8 where the Supreme Court held that a plan of reorganization may not provide for the sale of collateral free and clear of the creditor’s lien without permitting the creditor to “credit-bid” at the sale. In Castleton, the seventh circuit used broad language in describing this holding, stating that “A plan of reorganization that includes a new investment must allow other potential investors to bid. In this competition, creditors can bid the value of their loans.” It seems that the seventh circuit would at least allow secured creditors to “credit-bid” the amounts they are due and owing on the value of their loans as part of an offer to purchase the equity in a reorganized debtor. This rule may even extend to unsecured creditors, given the broad language used by the seventh circuit. If so, it would make it much more difficult, if not impossible, for the pre-petition shareholders to keep their equity in the reorganized debtor by allowing creditors to drive up the price of the equity in the reorganized debtor. The creditors would not have to pay actual dollars for the equity, instead using the “credit-bidding” process to bid on their ownership interest. Perhaps this was the intention of the seventh circuit in rendering its opinion, although allowing a creditor to “credit-bid” the value of its debt may not add much value to the bankruptcy estate. By way of example, an owner’s proposed contribution of $10,000 in many chapter 11 cases would likely add more to a bankruptcy estate than a creditor’s credit-bid of $10,000. This is because, in most bankruptcy cases, the creditors will receive less than 100% of what they are owed. For example, in a plan where creditors are to be paid 10% of what they are owed, a creditor’s credit bid would be worth only 10% of what the actual credit bid is. A creditor who makes a credit bid of $10,000 only adds value of $1,000 to the estate when creditors are to be paid 10% of what they are owed. Thus, the creditor would need to make a credit bid of $100,000 to equal a cash contribution of $10,000 being made by an equity owner. Courts should take this into account when allowing creditors to credit-bid against the former owners to obtain the equity interest in a reorganized debtor.
C o n c l u s i o n. The seventh circuit’s holding in Castleton is to be expected given the holding of the Supreme Court in 203 North La Salle Street Partnership; however, its reasoning in reaching its conclusion and broad-sweeping language could have potential implications on many future cases in the seventh circuit and in other jurisdictions. The court’s reasoning gives creditors who are unhappy with proposed plans of reorganization substantial leverage. The prospect of losing their equity interest in a reorganized debtor could be a strong motivating factor that could be used by creditors to drive up the contribution being made by the former equity holders. Attorneys representing corporate chapter 11 debtors should advise their clients of Castleton’s reasoning and warn the owners that they could potentially lose their ownership interest in the reorganized debtor to the very creditors they sought to rid themselves of in the bankruptcy.
1 11 U.S.C. §507(a)(8).
2 11 U.S.C. §1129(b)(2)(B)(ii).
3 526 U.S. 434 (1999).
4 707 f.3d 821 (7th cir. 2013).
5 11 U.S.C. §101(31)(B)(vi).
6 In re krehl, 86 f.3d 737, 741-42 (7th cir. 1996).
7 Id. at 741.
8 132 S. ct. 2065 (2012).
Joshua D. Greene is a Senior Associate with the law firm of Archer Bay, P.A. with offices in Lisle, Illinois. Mr. Greene focuses his practice in chapters7 and 11 bankruptcy proceedings, bankruptcy litigation, workouts and post-judgment proceedings. Mr. Greene represents businesses, individuals, debtors and creditors in all aspects of bankruptcy and insolvency proceedings.