Many years ago, one of the co-authors of this article attended a bankruptcy judges' conference and sat in on a session on bankruptcy appellate practice. The panelists — all highly respected circuit court jurists — reminded the audience of bankruptcy lawyers that only 5 percent of all appeals involved bankruptcy, and, unlike the bankruptcy lawyers in the audience, circuit court judges do not spend 100 percent of their time developing and advocating technical arguments under various provisions of the Bankruptcy Code. That being said, often a review of an appellate court opinion reminds us the issue presented for adjudication was not difficult to resolve. One such example is a decision issued by the U.S. Court of Appeals for the Seventh Circuit several months ago in a case styled In re Castleton Plaza LP, No. 12-2639 (7th Cir. February 14, 2013).
The court's opinion, authored by Chief Judge Frank H. Easterbrook, begins with a statement of one of the basic principles of bankruptcy law: "Creditors in bankruptcy are entitled to full payment before equity investors can receive anything. … This is the absolute priority rule." Further, in 1999, the U.S. Supreme Court, in Bank of America National Trust and Savings Association v.203 North LaSalle Street Partnership, 526 U.S. 434 (1999), held when the old equity proposes to contribute new value to retain the equity and control of the reorganized company, other potential investors should have the opportunity to bid. The issue presented in Castleton Plaza was whether the wife of the debtor's equity owner — an insider — could purchase the new equity (and control of the company) without competitive bidding over the objection of the creditor that held 99 percent of the debt of the debtor, something the existing equity holder himself would not be allowed to do. Although the answer seems obvious, no circuit court of appeals had reviewed this issue previously, and there was no clear direction under case decisions issued by the bankruptcy courts.
Owner's Wife to Receive Control Over Objections
According to the opinion, Castleton Plaza (the debtor) owned an Indiana shopping center. George Broadbent owned 98 percent of Castleton's equity directly, and the other 2 percent indirectly. EL-SNPR Notes Holdings was Castleton's only secured lender. The note held by EL-SNPR matured in September 2010, carried interest at 8.37 percent, and the loan documents had provisions to protect EL-SNPR, such as lockboxes for tenants' rents and approval rights for major leases. EL-SNPR was owed about $10 million. Approximately one year after filing its bankruptcy petition, Castleton filed a reorganization plan that proposed to (1) pay EL-SNPR $300,000 at confirmation; (2) write down EL-SNPR's remaining secured debt to $8.2 million, with the difference treated as an unsecured claim; (3) pay the $8.2 million over 30 years, with little principal reduction until 2021; (4) cut the interest rate from 8.37 percent to 6.25 percent, which the opinion notes is an exceptionally low rate for credit representing 97 percent of the estimated value of the borrower's assets; and (5) abolish all of EL-SNPR's covenant protections under the note, such as the lockbox and lease approval rights. The plan proposed to pay unsecured creditors 15 percent of their claims over five years. Obviously, the lender was not satisfied with the treatment of its claim.
The plan proposed that 100 percent of the equity of the reorganized debtor would go to Mary Clare Broadbent, George Broadbent's wife. Mary Broadbent would invest only $75,000. She also owned The Broadbent Co. Inc., the entity that managed Castleton Plaza and employed George Broadbent as CEO for an annual salary of $500,000. The plan provided that the services contract between Castleton and the management company would be continued.
As such, the case involved one asset — the shopping center — and ultimately, who would own the property. Other than EL-SNPR's $10 million loan, Castleton only owed various other creditors a total of about $338,000. Notwithstanding the treatment of the EL-SNPR claim and the sale of the equity to the equity owner's wife without competitive bidding, the bankruptcy court confirmed the plan over the lender's objection, noting the Bankruptcy Code did not expressly prohibit an insider of the equity holder from acquiring Castleton and Mary Broadbent was an experienced manager of 10 other shopping centers. The bankruptcy court certified a direct appeal and the Seventh Circuit accepted it because no court of appeals has addressed whether, after the Supreme Court's decision in 203 North LaSalle, the competition requirements could be "evaded" when the new value is contributed by an insider. As the opinion states, "The bankruptcy judge answered yes; our answer is no."
New Value Plan Must Allow Competitive bidding
The opinion notes that, in 203 North LaSalle, the Supreme Court held competition is the means of ensuring that the new investment benefits creditors and the estate, and a new value plan must allow other competitive bidding to protect creditors from plans giving too much value in exchange for the new investment.
Under the plan in the case at hand, Mary Broadbent was to invest $75,000 and receive all of the reorganized debtor's equity. EL-SNPR argued that Castleton's assets had been undervalued and that the equity in the reorganized business would be worth much more than $75,000. EL-SNPR offered to pay $600,000 for the debtor's equity and pay all other creditors in full. Castleton rejected that proposal but increased Mary Broadbent's proposed new value investment to $375,000. The bankruptcy court rejected EL-SNPR's position that acceptance of the debtor's plan be conditioned on Mary Broadbent making the highest bid in an open bid competition, and confirmed the debtor's proposed plan.
The opinion notes that bankruptcy courts have disagreed on whether competition is essential when a plan of reorganization gives an insider an option to purchase equity in exchange for new value. The bankruptcy court in this case concluded that competition was not needed because the absolute priority rule prevents benefits from flowing to "the holder of any claim" junior to impaired creditor's claim. Here, Mary Broadbent did not hold a claim. The Seventh Circuit disagreed, and stated: "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 court reasoned that value to the owner's spouse constituted value to the owner. The opinion describes examples where bankruptcy law treats insiders of equity investors the same as the equity investor itself. The opinion also observes George Broadbent would receive value from the equity that his wife would obtain under the plan by continuing to receive his salary from the management company and his family's wealth being increased, which is relevant because under Indiana law, each spouse has a presumptive interest in the other's wealth.
The court reasoned it was George Broadbent, through his control of the debtor, who set the new value investment at $75,000 (and then $375,000), and the difference between that amount and the amount the equity would fetch at auction would constitute value to his family. Finally, the court reasoned that if the Broadbents were correct that the plan offered creditors the best deal, the Broadbents would prevail at auction. If, on the other hand, EL-SNPR was correct and the bankruptcy court had undervalued the debtor's assets, stripped too much of the secured debt, and overreached in altering the terms of repayment of the remaining secured loan, someone would be willing to pay more for the debtor's equity. The court reversed the judgment of the bankruptcy court and remanded the case with instructions to subject the proposed plan to competitive bidding.
This case reminds us of the old saying, "If it seems too good to be true, it probably is." Non-bankruptcy practitioners (and many lenders' counsel) often advise their clients that bankruptcy courts favor reorganization and provide the debtor every opportunity to restructure its affairs, especially when the creditors appear unwilling to compromise and cooperate in a consensual resolution. Often unsecured creditors receive pennies on the dollar and secured lenders get paid at less than par over a number of years. What this decision demonstrates is if such an outcome is to occur without the assent of creditors, it should be the result of a competitive process that maximizes value.
Andrew C. Kassner is the chair of the corporate restructuring practice group of Drinker Biddle & Reath, practicing in the firm's Philadelphia and Wilmington, Del., offices. He can be reached at email@example.com or 215-988-2554. Joseph N. Argentina Jr. is an associate in the firm's corporate restructuring practice group in the Philadelphia and Wilmington offices. He can be reached at firstname.lastname@example.org or 215-988-2541.