203 North LaSalle Street – A Dead End
The hype in the bankruptcy world made the marketing for the Star Wars prequel look tame. This case had all the hot Chapter 11 issues - new value, separate classification, discrimination of treatment between unsecured classes. The Supreme Court in Ahlers ducked the new value issue, Bonner Mall settled before oral argument - this case was the one. Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership was the case in which the Supreme Court would put an end to the uncertainty as to whether equity holders in a Chapter 11 debtor could cram down an undersecured creditor and retain their interest in the debtor-entity.
In a classic, perhaps painful, example of judicial restraint, however, Justice Souter for an 8-1 majority held that, if a new-value exception to the absolute priority rule existed, or to use the Court’s apparent preferred term, if the new-value corollary to the absolute priority rule existed, it could only be invoked if the debtor relinquished exclusivity or if other parties were afforded the opportunity to bid on the equity interest. The Court expressly did not decide "whether the statute includes a new-value corollary or exception." Furthermore, the Court stated that the issue of separate classification of an unsecured deficiency claim was not appealed, and therefore, was not before the Court.
One has difficulty imagining a case in which the cram down issues involving a closely held entity would be more clearly presented to the Supreme Court than were presented in 203 North LaSalle Street. Bank of America held a claim in the amount of $93 million, secured by collateral worth $54.5 million. During the 120-day period in which the debtor had the exclusive right to file a plan of reorganization, 203 North LaSalle Street Partnership filed a plan that bifurcated Bank of America’s claim into a secured claim equal to the $54.5 million value of its collateral, and an unsecured claim equal to the $38.5 million deficiency. The debtor’s plan established a class of unsecured trade creditors, which held claims totaling $90,000, in a separate class from Bank of America’s $38.5-million unsecured deficiency claim. Bank of America’s secured claim was to be paid over a seven to ten-year period, the trade creditors’ class was to receive full payment without interest, and the bank’s $38.5-million unsecured claim was to receive a 16 percent return. The plan and the debtor’s operations were to be funded in part by capital contributions in the amount of $6.125 million from the debtor’s existing partners over a five-year period. In exchange for that contribution, the contributing equity holders were to retain their partnership interest.
While the Bankruptcy Code provides for the very bifurcation of an undersecured claim that was undertaken by the debtor in the 203 North LaSalle Street case, the interpretation given to other provisions of the Bankruptcy Code by some courts can make it difficult to invoke that bifurcation right without the undersecured party’s consent. The first weapon of the secured creditor, and an obstacle facing a debtor, is the Bankruptcy Code’s prohibition against confirmation of a plan unless the plan is either/accepted by a majority in number of creditors holding two-thirds in dollar amount of claims in each class of claims, or "crammed down" on a dissenting class of creditors after satisfaction of all applicable confirmation requirements. Because a secured party is entitled to have the secured portion of its claim in its own class, a lien holder knows that by voting its secured claim against a plan it can force a debtor into the uncertain world of cram down. In the 203 North LaSalle Street case, Bank of America’s secured claim was placed in its own class, and the bank voted that claim to reject the debtor’s plan. The debtor, therefore, was forced to attempt cram down.
A condition to confirming a plan through a cram down is that the debtor obtain the acceptance of a non-insider impaired class of creditors. In the 203 North LaSalle Street case, the debtor achieved that precondition through the combination of "separately classifying" Bank of America’s $38.5-million unsecured deficiency claim from the unsecured trade claims and obtaining the vote of the trade claims in favor of the plan. In many jurisdictions, Bank of America’s unsecured deficiency claim would have to be placed in the same class as the unsecured trade debt.
In those jurisdictions, the case law prohibition against separate classification would give the bank an effective veto over confirmation of the debtor’s plan because the amount of the bank’s unsecured claim was well in excess of the amount needed to preclude other unsecured creditors from obtaining the required amount of claims necessary to accept the plan. The Supreme Court did not address the propriety of separate classification, however.
The final arrow in the quiver of a creditor seeking to fight off cram down is the "absolute priority rule." As set forth in the Bankruptcy Code, the absolute priority rule provides that no class of claims or interests junior to a class of dissenting unsecured claims may receive or retain anything "on account of" their prepetition claim or interest unless the more senior dissenting class of claims is paid in full.
As argued by cram down targets, including Bank of America in 203 North LaSalle Street, this statutory provision means that partners and other equity holders can retain no interest in the debtor after a cram down unless all unsecured claims are paid in full. The 203 North LaSalle Street Partnership, argued that the "on account of" language suggests that an equity holder that makes a contribution of fresh capital, referred to as a "new value contribution" can retain an interest despite plan rejection by a creditor class because that equity holder is receiving that interest on account of the capital infusion, and not because of a prepetition interest in the debtor.
The Supreme Court had previously had the opportunity to decide whether this new-value exception to the absolute priority rule existed in the case of Norwest Bank Worthington v. Ahlers. The Court declined to decide the issue in the Ahlers case, determining instead that, if the exception did exist, it was not satisfied by the non-monetary sweat equity the debtors in that case proposed. The Court granted certiorari in In re Bonner Mall Partnership, a case in which the Court of Appeals for the Ninth Circuit held that the new-value exception did exist. Because that case settled, the appeal was dismissed before the Court could reach the issue.
Finally faced with an opportunity to end the uncertainty, the Court in 203 North LaSalle Street went the route of Ahlers. After substantial interpretive gymnastics as to the meaning and significance of the words "on account of" in the Bankruptcy Code’s codification of the absolute priority rule, the Court’s majority, through Justice Souter, stated that it was not necessary to decide whether a new-value exception, or corollary, to the absolute priority rule existed because the debtor’s plan, "is doomed we can say without necessarily exhausting its flaws, by its provision for vesting equity in the reorganized business in the debtor’s partners without extending an opportunity to anyone else either to compete for that equity or to propose a competing reorganization plan." The Court reasoned that the plan provision affording the partners in the 203 North LaSalle Street Partnership the exclusive right to make a new-value contribution constituted granting those equity holders a property interest, the option to make a capital contribution in exchange for equity, on account of their prepetition interest in the debtor. Therefore, before getting to the issue of whether a new-value exception exists, the Court determined that the plan in 203 North LaSalle Street violated the absolute priority rule’s prohibition against receiving an interest on account of prepetition equity.
Although the decades-old question of whether the new-value exception to the absolute priority rule remains, it is clear that, for a debtor to invoke the perhaps non-existent exception to the absolute priority rule, the debtor must subject its equity to market forces. The 203 North LaSalle Street decision suggests, without deciding, that terminating the debtor’s exclusive right to file a plan of reorganization, thereby affording other parties in interest the ability to file competing plans, would suffice.
In order to avail itself of that opportunity, however, a creditor attempting to fend off a cram down would have to be willing to comply with all of the requirements of confirming a plan of reorganization, including ensuring that all priority claims, including the fees of debtor’s counsel, creditors committee counsel and other estate functionaries, are paid in full.
The other alternative mentioned by the Court is opening up the equity under the plan to bidding. The practicalities of such a bidding procedure, such as how broadly the opportunity to bid must be offered and whether the bidding is for the equity interest in the debtor as it would be if the debtor’s plan were confirmed or in some other form that could be proposed by the successful bidder, were left for future determination.
At base, the Supreme Court’s decision in Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership provides some restrictions on a debtor’s invoking what may be a non-existent exception to the absolute priority rule. The determination that exposing the equity to market forces is a precondition to utilizing the new-value exception does not alter, in most jurisdictions, the negotiation landscape dramatically.
Except in the most debtor-friendly districts, creditors have always had in their arsenal of tactics the threat of seeking an order terminating the debtor’s exclusive right to file a plan and filing a competing plan. The other option referenced by the Supreme Court, satisfying market exposure requirements by subjecting the equity to bidding, had been required by some courts prior to 203 North LaSalle Street. Not surprisingly, there have been few bidders willing to outbid equity in order to step into their shoes as owners of a debtor operating under the terms of a plan drafted by those same equity holders.