In a case of first impression at the appellate level, the court, in an opinion by Chief Judge Frank H. Easterbrook, said that an equity investor cannot evade the competitive process during the reorganization “by arranging for the new value to be contributed (and the new equity to go to) an 'insider.' ” The issue has split the bankruptcy courts.
Alan K. Mills, Barns & Thornburg, Indianapolis, who argued for the lender, told BNA Feb. 15, that under the Seventh Circuit's approach lenders will have an opportunity to bid on equity and perhaps even gain control of the debtor. He praised the opinion for being the first appeals court opinion to apply the absolute priority rule to insiders. He also said that he hopes other appeals courts follow the lead of the Seventh Circuit, because the tactics used in the case are favored by insiders.
On the other hand, Paul T. Deignan, Taft Stettinius & Hollister, Indianapolis, who argued for the debtor, told BNA Feb. 19 that the case is not good news for small, family-owned businesses. He said that the opinion makes it harder for small businesses to reorganize because new capital for a family-owned business usually comes from other family members.
Deignan said that by applying the absolute priority rule to bankruptcy “insiders,” which includes family members, the opinion restricts the number of people who can come forward and help a small business debtor survive. He added that there should be considerable interest in the bankruptcy bar over this opinion, and that bankruptcy attorneys need to think it through and figure out a way to apply it to help their clients. He suggested that maybe the best way to avoid the results of this opinion is, if possible, find a way for the debtor to pay off its debts in full and avoid the absolute priority rule all together.
For his part, Mills said that to be successful in similar cases in the future, bankruptcy attorneys need to be sure to lay the proper groundwork during trial for the issues on appeal, such as showing that there is a higher market value for the property than that offered by the insider; pay attention to the full scope of the absolute priority rule; and have a good understanding of all the local bankruptcy rules. He also noted that while the case deals with insiders, its reasoning can also be applied to others.
Castleton's reorganization plan proposed to pay EL-SNPR's $10 million in secured debt by giving it $300,000 up front, and writing down the remainder to $8.2 million, which would be treated as an unsecured debt. The interest on the debt would also be reduced, and it would be paid down over 30 years, but the bulk of the payments would not start until 2021.
Unpaid creditors normally receive the equity in a reorganized business, but Castleton's plan cut them out of any equity interest. Because the plan paid EL-SNPR less than its contractual entitlement, the Bankruptcy Code provides that Broadbent could not retain any equity interest in his old investment.
Further, under Bank of America National Trust & Savings Ass'n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999), a reorganization plan that includes a new investment must allow other potential investors to bid. In this competition, creditors may bid the value of their loans. This process, the court here said, protects creditors against plans that give competing claimants too much for their new investments and dilute the creditors' interest.
In this case, 203 North LaSalle required an auction before Broadbent could receive equity through his new investment. At the same time, however, the plan provided that 100 percent of the equity in the reorganized Castleton would go to Broadbent's wife, Mary Clare, who would invest $75,000.
Mary Clare owns all of the equity in the Broadbent Co., which runs Castleton under a management contract that the reorganization plan allows to continue. George Broadbent is CEO of the Broadbent Co. and receives an annual salary of $500,000.
After EL-SNPR complained that the plan undervalued Castleton's assets, a revised plan increased Mary Clare's proposed investment to $375,000. EL-SNPR asked the bankruptcy court to condition acceptance of the plan on Mary Clare making the highest bid in open competition. The bankruptcy court said that competition was unnecessary and confirmed the plan.
The bankruptcy court thought that competition was unnecessary because Mary Clare does not own an equity interest in Castleton, and Section 1129(b)(2)(B)(ii) of the Bankruptcy Code, which sets out the absolute priority rule and says that creditors are entitled to full payment before equity investors can receive anything, deals only with “the holder of any claim” that is junior to the impaired creditor's claim.
The appeals court said, however, that 203 North LaSalle does not interpret the language of Section 1129(b)(2)(B)(ii), “which does not speak to new-value plans.” It said that the U.S. Supreme Court created the competition requirement to stop evasion of the absolute priority rule. “A new-value plan bestowing equity on an investor's spouse can be just as effective at evading the absolute-priority rule as a new-value plan bestowing equity on the original investor,” the appeals court said.
Family members are insiders under the Bankruptcy Code, and in 203 North LaSalle, the Supreme Court noted the dangers created for the absolute priority rule by divesting assets to insiders. “It follows that plans giving insiders preferential access to investment opportunities in the reorganized debtor should be subject to the same opportunity for competition as plans in which existing claim-holders put up the new money,” the Seventh Circuit said.
In this case, George Broadbent had control over the proposed plan and will benefit from it, the court said. “The absolute-priority rule therefore applies despite the fact that Mary Clare had not invested directly in Castleton,” it said. It added that an impaired lender who objects to a plan that leaves insiders holding equity “is entitled to the benefit of competition.”
Judges Joel M. Flaum and Ilana Diamond Rovner joined the opinion.
Deignan argued for Castleton. Mills argued for EL-SNPR.
By Bernard J. Pazanowski
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