Refining the Absolute Priority Rule and the New Value Exception

• Publication year: 2000
• Pages: 39

29 Colo.Law. 39 Colorado Lawyer 2000.

2000, April, Pg. 39. Refining the Absolute Priority Rule and The New Value Exception

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39

Vol. 29, No. 4, Pg. 39

The Colorado Lawyer
April 2000
Vol. 29, No. 4 [Page 39]

Specialty Law Columns
Business Law Newsletter
Refining the Absolute Priority Rule and The New Value Exception
by Duncan E. Barber, Philip C. Zimmerman

When a company is suffering financial distress and is either insolvent or nearly so, the owners and managers often ask whether they would be prevented from ownership and management of the company in a Chapter 11 bankruptcy. The traditional corporate rule prefers the distribution of a company’s assets to the payment of creditors’ claims over the interests of owners This question has perplexed courts and commentators for more than 100 years.1

The answer is currently grounded in the Absolute Priority Rule and New Value Exception, which the U.S. Supreme Court recently addressed in Bank of America v. 203 North LaSalle Street Partnership.2 This case may influence the extent to which owners and managers can continue to participate in a company’s financial fortunes after the filing of a bankruptcy petition. This article discusses important issues implicated by the Absolute Priority Rule and New Value Exception and describes how these major concepts relate to the LaSalle decision

The Absolute Priority Rule and the New Value Exception

Stated simply, the Absolute Priority Rule contained in Bankruptcy Code ("Code") § 1129(b) bars junior stakeholders,3 such as subordinated debt-holders and equity interests, from receiving or retaining any corporate property under the Chapter 11 plan of reorganization, unless the claims of dissenting senior stakeholders are paid in full Under the Absolute Priority Rule, pre-bankruptcy equity owners are entitled to receive property only in a solvent case in which creditors are paid in full. The Absolute Priority Rule, therefore, reflects the fundamental subordinate nature of equity to debt by ensuring full payment of creditor claims before any property is distributed to "old equity" under a plan of reorganization. The Rule also attempts to maintain the priorities among creditors under applicable non-bankruptcy law.

Under current bankruptcy law, a plan of reorganization can be confirmed and thus become binding on a debtor’s creditors and owners post-confirmation, only if one of two alternative requirements4 is satisfied: (1) all impaired5 classes vote in favor of the plan; or (2) the plan satisfies Code § 1129(b). In the first alternative, court approval of a creditor-accepted plan is consistent with congressional intent that the debtor and creditors be afforded considerable latitude in developing consensual reorganization plans under Chapter 11.6 However, in the second alternative, court approval of plans under Code § 1129(b), in which not all creditor classes consent to the plan, is considerably more difficult to obtain.

To invoke its rights provided under Code § 1129(b), the impaired class of stakeholders must have rejected the plan. An impaired objecting class then can insist on the absolute priority of its rights to be paid in preference to junior stakeholders, while the debtor can ask the court to approve the plan over the objection of the dissenting impaired class. Thus, Code § 1129(b) gives each class of dissenting stakeholders the right to insist on full payment if any junior class of stakeholders is to receive a distribution under the plan.7 This reflects the "absolute priority" aspect of Code § 1129(b) and the application of the fundamental rule of corporate law in formal bankruptcy proceedings.

On the other hand, Code § 1129(b) also permits the debtor to confirm a plan over the rejection of a class of stakeholders, as long as the debtor demonstrates that the plan satisfies Code § 1129(b), which provides, among other things,8 that no junior class of stakeholders can receive or retain property under the reorganization plan "on account of" stakeholders’ pre-bankruptcy rights or interests. By invoking the New Value Exception, a debtor, or more accurately, a debtor’s management or pre-bankruptcy ownership, can overcome the rule of absolute priority so that, notwithstanding the fact that creditors will not be paid in full, pre-bankruptcy owners can retain the ownership of the post-confirmation debtor.9

Although the New Value Exception is stated somewhat differently by the courts and commentators who have addressed the issue, the elements generally include the following: "First, the new value must be given in cash or something roughly equivalent to cash; second, the new value must be a ‘necessity’ for reorganization; and third, the payment must be roughly equivalent to the going-concern value of the business."10

Valuation, Control, And New Value

The Absolute Priority Rule and New Value Exception reflect two important, but competing, policies. First, there is judicial concern that the fundamental corporate rule regarding the preference of creditors over owners to corporate assets be adhered to in federal insolvency proceedings, including both formal bankruptcy proceedings and "equity" receiverships. This policy makes extremely difficult the confirmation of a Chapter 11 reorganization plan that provides...