By the time restructuring and rescue reaches the bankruptcy court, a distressed company, in most circumstances, inevitably faces a change of control transaction. That economic posture often prompts investment in the company’s debt by sophisticated parties seeking to play an "outcome determinative" role in the reorganization by gaining control of the company. At times, a bankruptcy judge confronts a debtor controlled by equity that is clearly "out of the money" but that nevertheless attempts to advance equity’s interests rather than pursue the maximization of estate value. In a recent case, Castleton,1 Judge Frank H. Easterbrook once again confirms the view he expressed over 20 years ago in Kham & Nate’s Shoes,2 which demands that in bankruptcy, where value is the keystone, the market must serve as the true indicator of value and guardian of fiduciary principles.

Navigating from intervening decisions by the Supreme Court in N. LaSalle3 (setting forth the requirements for "out of the money" equity investing new value under a Chapter 11 plan to retain control of the reorganized debtor) and RadLAX4 (confirming that secured creditors have the right to credit bid on a sale of the debtor under a Chapter 11 plan), Easterbrook holds that a Chapter 11 plan relying upon new investment from an insider of the debtor must meet the same competitive bidding standard applicable to new-value plans premised upon investment by existing equity.

In Castleton, Bankruptcy Judge Basil Lorch certified direct appeal to the Seventh Circuit on the question of whether a Chapter 11 plan premised upon a new investment by the wife of the debtor’s controlling equity holder was insulated from value-based review by the debtor’s reliance upon its exclusive right to propose a plan. The appellant—a distress investor that acquired the debtor’s first-lien secured debt—rejected the plan, but the general unsecured creditors accepted it. The bankruptcy court overruled objections raised by the secured creditor and confirmed the plan, cramming down the secured creditor under the "fair and equitable" standards applicable to nonconsensual Chapter 11 plans.

Interestingly, the appellant, who had offered a greater cash price for the equity than what the plan provided, contended on appeal that the Chapter 11 plan failed to meet several of the confirmation requirements and improperly classified claims to gerrymander a favorable vote for unsecured creditor class. Rather than parse through the technical requirements of §1129 of the Bankruptcy Code, however, Easterbrook turned to the market, including creditor bids, as the true test of value, and reversed the confirmation order. Castleton mandates that insider-investors under a Chapter 11 plan poised to gain control of the reorganized debtor must be subject to the same competitive bidding requirements applicable to the old "out of the money" equity, clearly rejecting the argument that the debtors’ exclusive right to propose a plan gave the debtor an unfettered right to choose which new investment to accept.

Background

Debtor Castleton Plaza (Castleton or Debtor) is an Indiana limited partnership whose sole asset (not including certain cash collateral) is a shopping plaza located in a desirable section of Indianapolis. George Broadbent owns 98 percent of Castleton directly and the other 2 percent indirectly through an incorporated general partner. George Broadbent’s wife, Mary Clare Broadbent, owns The Broadbent Company, a commercial property management company that manages the Castleton property and employs George Broadbent as CEO.

In 2000, Castleton obtained a $9.5 million loan at 8.37 percent interest to finance the purchase, operation and maintenance of the Castleton property. An associated promissory note included a mortgage and security agreement, an assignment of leases and rents and an absolute and unconditional guaranty in favor of the lender, all of which encumbered substantially all of Castleton’s property. Castleton’s mortgage also included certain restrictions on Castleton, including the maintenance of reserve accounts controlled by the lender, and the use of a lockbox account for rents.

Castleton’s promissory note matured by its terms on Sept. 1, 2010 and required Castleton to make a balloon payment. When Castleton could not make the payment, the lender commenced a state court foreclosure action. Subsequently, the lender sold its rights to the Castleton debt at a discount to EL-SNPR Notes Holdings. On Feb. 16, 2011, Castleton filed for Chapter 11 bankruptcy in the Southern District of Indiana.

EL-SNPR filed a secured claim against Castleton for about $10.2 million, representing the outstanding amount Castleton owed under its loan. There were also about $280,000 in secured tax claims against Castleton and approximately $56,000 in unsecured trade debt.

In July 2011, Castleton filed a motion to determine the amount of EL-SNPR’s allowable secured claim. After valuation testimony from the Debtor and EL-SNPR, the court determined that the Castleton property was worth $8.25 million. EL-SNPR has maintained throughout the plan process that the Debtor’s business is undervalued.

Castleton’s Plan

The Debtor’s plan purported to satisfy the secured tax claims in full over three years. EL-SNPR’s secured claim was allowed at $8.9 million after accounting for cash on hand. The plan contemplated an initial $300,000 payment to EL-SNPR, followed by monthly installments pursuant to an amended promissory note. Interest on the amended note was reduced to 6.25 percent, and the note was secured by an amended mortgage and amended assignment of leases and rents. After 10 years, the loan documents required Castleton to make a balloon payment of about $7.3 million, or approximately 85 percent of the present value of the shopping plaza. Both EL-SNPR’s $1.3 million unsecured deficiency claim and the separately-classified trade debt would recover at 15 percent of value. The plan provided no recovery for prepetition equity.

As originally conceived, the plan contemplated the issuance of 100 percent of the reorganized equity to George Broadbent’s wife for $75,000. The equity investment was exclusively extended to Mary Clare Broadbent as part of a Chapter 11 plan proposed at a time in which only the debtor had the right to propose a plan. The price tag was determined internally based on the company’s projected capital needs after emergence from Chapter 11, rather than any market test. One of Castleton’s officers testified that the company had not been approached by any other potential buyers, and that the Debtor did not believe there to be a market for the assets despite the offers made by its secured creditor.

EL-SNPR objected to plan confirmation, raising arguments related to the improper classification of claims, the feasibility of the plan, the good faith of the Debtor in proposing it and the failure to meet the "cramdown" requirements of §1129(b) of the Bankruptcy Code as they applied to EL-SNPR’s secured claim and its unsecured deficiency claim. EL-SNPR argued that the plan could not be "crammed down" over its objection because EL-SNPR had offered a greater value for the reorganized equity and offered to pay unsecured claims in full. Reasoning from N. LaSalle, EL-SNPR argued that the rejection of its offer stood as evidence that the plan indeed provided value to the old equity before paying creditors in violation of the absolute priority rule, which is the heart of the Bankruptcy Code’s "fair and equitable" standard.

At the plan confirmation hearings, EL-SNPR testified that it would pay $300,000 for the reorganized Castleton. In response, Mary Clare Broadbent promised to increase her purchase price to $375,000. EL-SNPR came back with a $600,000 offer, indicating that it would immediately pay the Debtor’s secured tax claims and remaining unsecured claims in full. The Debtor rejected EL-SNPR’s proposal, and EL-SNPR requested that the court condition approval of the Castleton sale on Mary Clare making the highest bid at an open auction. EL-SNPR also asserted that the undervaluing of Castleton and the plan’s treatment of EL-SNPR’s secured claim would pique the interests of potential bidders.

Nevertheless, the bankruptcy court overruled EL-SNPR’s objection, observing that EL-SNPR had no property management experience and that a majority of Castleton’s unsecured claimants had supported the plan. On absolute priority, the court found that the rule applied to equity holders, and did not extend to insiders such as Mary Clare Broadbent, and N. LaSalle neither addressed nor prohibited such a debtor-directed change of control to an insider.

Upon EL-SNPR’s request, the bankruptcy court granted certification for direct appeal to the Seventh Circuit on July 11, 2012.

Absolute Priority and ‘N. LaSalle’

When a class of unsecured creditors rejects a plan, the absolute priority rule applies, mandating that no value be paid or retained by equity until the rejecting unsecured creditors are paid in full. The "cramdown" confirmation standards of the Bankruptcy Code prohibit confirmation of the plan if junior interest holders (i.e., equity) receive any property on account of their junior claim. Yet, the "new value corollary" arguably allows holders of prepetition equity to make a new investment—even over the objection of an impaired senior class—if the equity holders contribute new value that is reasonably equivalent to the value of property received or retained, and is necessary to the reorganization. Under such circumstances, distributions to an equity class would not be "on account of" their equity status, but rather on account of a new contribution.

The Supreme Court in N. LaSalle held that extending to equity holders the exclusive opportunity to acquire equity in the reorganized entity was a valuable item of property received on account of the old equity position.5 The court stopped short of endorsing the "new value corollary" to the absolute priority rule, but held that, even assuming such a corollary, "plans providing junior interest holders with exclusive opportunities free from competition and without benefit of market valuation fall within the prohibition of [the absolute priority rule]."6 Market competition, the court observed, was key to determining the benefit to the estate of a new value plan.7

Seventh Circuit Decision

Easterbrook began his analysis with the dual observation that (a) given the impairment of EL-SNPR’s unsecured deficiency claim, George Broadbent could not retain any estate property on account of his old investment, and (b) under N. LaSalle, he could not receive equity on account of any new investment absent competitive bidding. Because Mary Clare Broadbent owned no equity interest in Castleton, the bankruptcy court had refused to apply the absolute priority rule to her as exclusive purchaser, and dismissed the argument that a competitive bidding process was necessary. Easterbrook averred, however, that N. LaSalle‘s competition requirement was devised to curb evasion of the absolute priority rule, and there was little difference between a new-value plan that handed new equity to the old owner, and one that handed it to the owner’s spouse.8

The court listed several rationales. First, the Bankruptcy Code treats insiders and equity holders the same in many circumstances, such as for preference recoveries under §547. Further, the court had no doubt that George Broadbent would receive value from Mary Clare’s purchase of the reorganized Castleton, whether directly from the continuation of his salary as CEO of The Broadbent Company, or indirectly as a member of Mary Clare’s household. Finally, the court analogized to tax law under which the power to appoint income or trust assets to another recipient is taxable as income to the appointer.9

Interestingly, the court stated that the competition requirement for sales to insiders would apply regardless of whether a plan is filed within the debtor’s "exclusivity period," and regardless of who proposes the plan. Indeed, the court concluded that "[a]n impaired lender who objects to any plan that leaves insiders holding equity is entitled to the benefit of competition."10

Conclusion

Castleton‘s language is stark: No matter who proposes a plan or when it is proposed, if the plan gives an insider the option to purchase equity in exchange for new investment, the investment process must be competitive. Easterbrook’s holding is entirely consistent with the core fiduciary principle governing debtors to maximize the value of the estate. It extends to insiders the requirements that new investment under a plan be at reasonably equivalent value and necessary for the reorganization.

While the value exchange and failure to maximize value may have been plainly evident in Castleton, given the spousal relationship and history, it is not always as clear in other situations. The bankruptcy definition of "insider" can be far reaching, as it embraces affiliates.11 The message to a debtor with a potential affiliated investor seems to be a binary one: Either gain the support of the unsecured creditor classes or be prepared to survive a competitive bidding process. Given the myriad situations in which the same investor holds creditor and equity positions, the lessons of Castleton may have wider application than Easterbrook realized. Yet, there should be no doubt that he would always favor the market determined approach to any contest!

Corinne Ball is a partner at Jones Day.

Endnotes:

1. In re Castleton Plaza, —F.3d—, 2013 WL 537269 (7th Cir. Feb. 14, 2013).

2. Kham & Nate’s Shoes No. 2 v. First Bank of Whiting, 908 F.2d 1351 (7th Cir. 1990).

3. Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 443 (1999).

4. RadLAX Gateway Hotel v. Amalgamated Bank, 132 S.Ct. 2065 (2012).

5. Id. at 455.

6. Id. at 458.

7. Id. at 456-57.

8. Castleton, at *2.

9. Id. at *3 ("Since the exercise of a power of appointment is treated as income in tax law, it should be treated as income for the purpose of §1129(b)(2)(B)(ii) too").

10. Id. (emphasis in original).

11. For example, for Corporate debtors, the term "insider" includes a(n): "(i) director of the debtor; (ii) officer of the debtor; (iii) person in control of the debtor; (iv) partnership in which the debtor is a general partner; (v) general partner of the debtor; or (vi) relative of a general partner, director, officer, or person in control of the debtor." 11 U.S.C. §101(31)(b).