On February 14, 2013, the US Court of Appeals for the Seventh Circuit held in In re Castleton Plaza, LP that an equity investor cannot evade the absolute priority rule by arranging for new value to be contributed by an insider and therefore receiving equity in the reorganized debtor. This holding reversed the ruling by the US Bankruptcy Court for the Southern District of Indiana. The Seventh Circuit reasoned that competition is essential when a plan of reorganization leaves an objecting creditor unpaid but distributes new equity to an insider on account of its capital contribution. It remanded the case to the Bankruptcy Court with directions to open the proposed plan to competitive bidding.

The absolute priority rule requires that creditors in bankruptcy must receive full payment on their claims before equity investors can receive any distributions (§ 1129(b)(2)(B)(ii), Bankruptcy Code). Equity investors sometimes argue that they can receive value ahead of creditors if the value received is due to new (post-bankruptcy) investments, rather than on account of their claims. However, the US Supreme Court held in Bank of America National Trust & Savings Ass'n v. 203 North LaSalle Street Partnership that this will only be allowed if the plan permits other potential investors to bid, which ensures that a new investment makes senior creditors and the estate better off (526 US 434 (1999)).

George Broadbent owned 98% of Castleton Plaza's equity directly and 2% indirectly. After Castleton Plaza filed for bankruptcy, it proposed a plan that cut its creditors out of any equity interest. The plan provided, among other things, that all of the equity in the reorganized entity would go to Broadbent's wife, who would invest $75,000. The sole secured lender held a claim for $10 million in secured debt. The lender believed that Castleton's assets were undervalued, and offered $600,000 for the equity and promised to pay all other creditors in full. The debtor rejected the offer, but proposed a revised plan that increased the wife's investment to $375,000. The bankruptcy judge confirmed the plan over the lender's objection, finding an open auction for the equity unnecessary.

At issue before the Seventh Circuit is whether competition is necessary when a plan of reorganization gives an insider an option to purchase equity in exchange for new value. Normally, the absolute priority rule of section 1129(b)(2)(B)(ii) of the Bankruptcy Code requires unpaid creditors to receive the equity in a reorganized business. However, under 203 North LaSalle, equity interest holders can retain some or all of their interests in exchange for making a substantial new capital contribution to the reorganized debtor if more senior creditors or interest holders can compete for the right to inject new capital into the reorganized debtor. Bankruptcy courts are split on whether 203 North LaSalle requires this competition when applied to insiders (such as relatives of corporate managers).

The Bankruptcy Court reasoned that competitive bidding was unnecessary in this case because the new value was contributed by an insider and section 1129(b)(2)(B)(ii) only deals with existing equity holders. The Seventh Circuit rejected this reasoning because the competition requirement established under 203 North LaSalle was intended to prevent evasion of the absolute priority rule and did not differentiate between new-value plans granting equity to the original investor and new-value plans granting equity to an insider. An insider is often treated the same as an equity investor under the Bankruptcy Code, and can pose the same dangers to the absolute priority rule.

The Seventh Circuit reasoned that competitive bidding is necessary to prevent the funneling of value from lenders to insiders in violation of the absolute priority rule. An impaired lender who objects to a plan that grants equity to insiders is entitled to the benefit of competition. Therefore, the Seventh Circuit reversed the Bankruptcy Court's ruling and remanded the case with directions to open the proposed plan to competitive bidding.

This is the first court of appeals decision since 203 North LaSalle to address whether an existing owner can evade the absolute priority rule and avoid competition by arranging for new value to be contributed by an insider. Competition ensures that existing owners do not retain control of a company under a plan that does not provide the best possible treatment for creditors. Following this decision, debtors must subject new-value plans to competitive bidding, regardless of who contributes the new value. Future courts may use this decision as support to strike down plans that technically comply with the absolute priority rule, but are clearly designed to defeat its purpose.

For more information on the confirmation of Chapter 11 plans, see Practice Note, Chapter 11 Plan Process: Overview.