The new value exception to the absolute priority rule after In re 203 N. Lasalle Street Partnership: what should bankruptcy courts do, and how can congress help?

• Author: Hoang, Hieu T.

INTRODUCTION

A company files for bankruptcy when it is no longer viable in its present condition. When a company files for bankruptcy under chapter 7 of the Bankruptcy Code (the "Code"), the company's assets are generally sold off in a piecemeal fashion, and the company is dissolved.(1) When a company files for bankruptcy under chapter 11 of the Code, however, the company is not liquidated but instead reorganized.(2) Some form of payment to the creditors satisfies claims against the company, most debts are discharged, and the company continues operating in essentially the same business, usually with the same management.(3) For creditors, the difference between these two forms of bankruptcy is that under chapter 7, the creditors will receive the cash value of the company's assets, while under chapter 11, the creditors will likely retain the company.

The reason that creditors may end up owning the company under chapter 11 is the absolute priority rule, enunciated in 11 U.S.C. [sections] 1129(b)(2)(B)(ii), which generally states that no junior creditors or interest holders, such as the owners of the indebted company, will retain any interest, which includes ownership in the reorganized company, before claims of senior creditors are satisfied. Since many debtors cannot satisfy the claims of their creditors, the creditors would usually end up owning the company.(4) Most creditors, however, do not want to end up running the reorganized company,(5) so they usually negotiate with the debtor--often before the debtor files for bankruptcy--to come up with a different solution.

Debtors can thus retain ownership and control of the reorganized company if the creditors consent.(6) Even if a class of creditors does not consent, a debtor can still retain ownership of the company if a plan of reorganization giving ownership in the company to old equity holders is imposed upon, or "crammed down" on, the creditors.(7) Such a plan of reorganization is called a "new value" plan. The name comes from the "new value exception," a judicially created doctrine that allows old equity holders to retain ownership in the company despite the absolute priority rule.(8) After Norwest Bank Worthington v. Ahlers, however, there was debate regarding whether a plan using the new value exception would be confirmable.(9) In Bank of America National Trust & Savings Ass'n v. 203 N. LaSalle Street Partnership (In re 203 N. LaSalle Street Partnership) (hereinafter 203 N. LaSalle), the Supreme Court declined to address the issue of whether the new value exception existed.(10) The Court, however, did reject the new value plan at issue, although it suggested that a new value plan that allowed for a market valuation would be confirmable.(11)

This Comment explores two methods that could satisfy the 203 N. LaSalle Court and still permit the debtor to file a new value plan. Part I examines the origin of the absolute priority rule from its beginnings in railroad bankruptcy to its current codification in the Code.(12) Part II traces the historical development of the new value exception from its origins in Case v. Los Angeles Lumber Products Co.(13) to its present existence after 203 N. LaSalle.

Part III examines how the new requirement imposed by 203 N. LaSalle could be satisfied either by allowing any party to submit competing reorganization plans or by allowing any party to make bids for the equity interest in the reorganized company. It explores how each process could occur under the Code and which method is preferable. Drawing upon auction theory, Part III shows that the two methods likely will yield the same result and suffer from many of the same weaknesses. The competing bids method is preferable, however, because it allows creditors to distinguish easily which reorganization plan will pay them more.

Part IV examines two considerations that would eliminate the need for a debtor to use either proposed method in filing a new value plan: (1) exclusion of single-asset real estate debtors from the use of the new value exception, and (2) equality of tax treatment for debtors filing under chapter 7 and chapter 11 of the Code. It argues that the Internal Revenue Code should be amended to reduce the incentives of single-asset debtors to file for bankruptcy under chapter 11.

Finally, this Comment argues that, barring amendment of the Internal Revenue Code, the bankruptcy court should apply the competing bids option to ensure that new value plans meet the requirements of 203 N. LaSalle.

1. A HISTORICAL REVIEW OF THE NEW VALUE EXCEPTION

   1. Chapter 11 of the Code

      One of the options available to debtors who are facing financial distress is bankruptcy.(14) Under [sections] 301 of the Code, a debtor can voluntarily commence a bankruptcy case by filing a petition under a bankruptcy chapter allowable to that debtor.(15) Chapter 11 is available to any debtor that wishes to reorganize its finances.(16) After successfully filing the petition,(17) the debtor has an exclusive period of 120 days to propose a reorganization plan.(18) A reorganization plan may be approved by all classes of creditors, in which case the bankruptcy court will likely confirm the plan.(19) Sometimes, one or more creditors may object to the proposed plan. In these situations, the debtor may modify the plan,(20) submit another reorganization plan,(21) or petition the bankruptcy court to "cram down"(22) the plan on all of the creditors.(23)

      To protect the creditors in the event of a cram down, the court will confirm a reorganization plan only if it meets certain requirements that are laid out in the Code. The court may confirm a plan that meets all of the requirements of [sections] 1129(a), or all of the requirements of [sections] 1129(a) except for (a)(8), which requires acceptance by all impaired classes.(24) In the latter case, the plan must also satisfy all of the requirements of [sections] 1129(b). In pertinent parts, [sections] 1129(b) provides that:

      (1) [T] he court ... shall confirm the plan ... if the plan ... is fair and equitable....

      (2) ... [T]he condition that a plan be fair and equitable ... includes the following requirements: ....

      (B) With respect to a class of unsecured claims--

      (i) the plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or

      (ii) 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.(25)

      Thus, a plan can be confirmed under [sections] 1129(b)(2)(B)(i) despite the objections of a class of creditors if the class of creditors would receive property equal to the amount of their allowed claims. Since a debtor filing for bankruptcy tends to be insolvent, the requirement of subsection (b)(2)(B)(i) is rarely satisfied.(26) Rather, most plans that are confirmed despite an objecting creditor satisfy the requirement of subsection (b)(2)(B)(ii)instead. Subsection (b)(2)(B)(ii) provides that a holder of a senior claim, such as an unsecured creditor with a deficiency claim, must be paid before a holder of a junior claim or interest, such as an equity holder, is paid. "[This] latter condition is the core of what is known as the `absolute priority rule.'"(27)

   2. The Absolute Priority Rule

      The absolute priority rule is a legal rule that requires a bankrupt firm to pay off its creditors in order of the claim holders' or interest holders' priority status. Under this rule, all creditors must be paid off before an equity holder can receive any property from the company. The absolute priority rule was the response to the perceived abuses of the railway receivership system during the beginning of the nineteenth century.(28)

      Reorganization via the railway receivership system was "carefully orchestrated."(29) Typically, a creditor petitioned a court of equity to appoint a receiver to take control of the debtor's assets and sell them for the benefit of the creditors.(30) The receiver then took title to all of the assets, and individual creditors could no longer levy on the railroad's assets.(31) Rather, the various creditors would meet and agree upon a plan of reorganization.(32) The reorganization plan created and empowered the reorganization committee and specified how much a creditor would receive after the reorganization process if she transferred her claims against the debtor to the committee.(33)

      With the plan in place, the receiver would then trigger a foreclosure sale and the reorganization committee would be the winning bidder at the foreclosure sale.(34) Next, the proceeds of the sale were distributed to the creditors in order of priority. This generally meant that the unsecured creditors were not paid.(35) Then, the reorganization committee would form a new corporation and transfer the assets from the old corporation to the new corporation. Those creditors who had transferred their claims to the committee would receive claims against the new corporation.(36) Those creditors who only had claims against the old corporation were out of luck since the old corporation would be dissolved.(37)

      This process was vulnerable to several kinds of abuses. First, the price that the committee would bid for the assets of the old firm was artificially low since the committee was generally the only bidder at the foreclosure sale.(38) To remedy this problem, there was a judicially imposed "upset price."(39) The upset price was the "minimum price that the reorganization committee would have to bid at the foreclosure sale to acquire the assets of the railroad."(40) As with any other price control, there were some problems.(41) If the upset price were too high, no one would bid for the assets since the assets were worth less than the price. The reorganization committee would not be able to bid for the assets since they would not...