May 31, 2016

The absolute priority rule is relevant in Chapter 11 cases where the debtor attempts to “cram down” a Chapter 11 plan over the objection of dissenting unsecured creditors. It is best to start with the requirements for confirmation. 11 USC 1129 addresses confirmation of a chapter 11 plan. 11 USC 1129(a) states, in relevant part:        

(a) The court shall confirm a plan only if all of the following requirements are met:

* * *

(8) With respect to each class of claims or interests —

(A) such class has accepted the plan; or

(B) such class is not impaired under the plan.

11 USC 1129(b) allows for nonconsensual confirmation, or "cramdown," if at least one impaired class votes in favor of the plan. 11 USC 1129(b) states:

Notwithstanding section 510(a) of this title, if all of the applicable requirements of subsection (a) of this section other than paragraph (8) are met with respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan notwithstanding the requirements of such paragraph if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.

Thus, assuming the debtor has met all of the other requirements of 11 USC 1129(a), 11 USC 1129(b) excuses the subsection (a)(8) requirement that none of the classes are impaired. In place of this requirement, 11 USC 1129(b) requires that: (1) the plan does “not discriminate unfairly”; and (2) the plan is “fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted the plan.”  In re G & D Inv. Props., LLC, 2014 Bankr. LEXIS 4946, *7 (Bankr. E.D. Mich. June 5, 2014).

11 USC 1129(b)(2) addresses the “fair and equitable” requirement, and it states, in relevant part:

(2) For the purpose of this subsection, the condition that a plan be fair and equitable with respect to a class 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, except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115, subject to the requirements of subsection (a)(14) of this section. [emphasis added.]

The language highlighted above states what is commonly known as the “absolute priority rule.” In re G & D Inv. Props., LLC, 2014 Bankr. LEXIS 4946, *7 (Bankr. E.D. Mich. June 5, 2014). The “absolute priority rule” is a limitation created due to “the danger inherent in any reorganization plan proposed by a debtor, then and now, that the plan will simply turn out to be too good a deal for the debtor’s owners.”  Bank of Am Nat'l Trust & Sav Ass'n v 203 N Lasalle St P'ship, 526 US 434, 444; 119 S Ct 1411; 143 L Ed 2d 607, 617 (1999).  In its simplest form, “the ‘absolute priority rule’ requires that dissenting unsecured creditors must be paid in full if a junior claim holder is to retain its ownership interest under the reorganization plan. In re Target Graphics, Inc., 372 B.R. 866, 871 (E.D. Tenn. 2007), citing 11 U.S.C. § 1129(b)(2)(B)(ii).

However, there is a well recognized exception to the “absolute priority rule.” The “new value” exception “provides the absolute priority rule is not a bar to confirmation if the shareholders contribute new capital in money or money’s worth, reasonably equivalent to the property’s value, and necessary for successful reorganization of the restructured enterprise.” In re Target Graphics, Inc., 372 B.R. 866, 872 (E.D. Tenn. 2007) (citation and quotation omitted). There are five requirements for the new value exception to apply: “1) new, 2) substantial, 3) money or money's worth, 4) necessary for a successful reorganization and 5) reasonably equivalent to the value or interest received.” In re RTJJ, Inc., 2013 Bankr. LEXIS 481, *31 (Bankr. W.D.N.C. Feb. 6, 2013)

The first and third requirements – new and money or money’s worth – tend to go hand-in-hand. More importantly, “money or money’s worth” is an amorphous concept that can take many different forms including, new money, rent-free contribution, or some other intangible that has money’s worth. This is important to remember because attorneys may be able to get creative in avoiding the absolute priority rule by having an entity or individual offer “something” that has money’s worth.

When the new money or money’s worth is injected into the debtor, an argument can be made that it is necessary for successful reorganization. One of the requirements for confirmation is the payment of administrative expenses. 11 USC 1129(a)(9). Even a small cash contribution can satisfy this important requirement of the new value exception. See In re RTJJ, Inc., 2013 Bankr. LEXIS 481, *31 (Bankr. W.D.N.C. Feb. 6, 2013) (finding a contribution of $20,000 to be necessary when it serves the important function of paying administrative expenses).

The second element can also be easily satisfied as the reorganized debtor is short on cash initially and any infusion of money or money’s worth is substantial when compared to the resources on hand. See In re RTJJ, Inc., 2013 Bankr. LEXIS 481, *31 (Bankr. W.D.N.C. Feb. 6, 2013) (finding a $20,000 contribution to be substantial because the debtor had limited cash resources). Thus, this requirement is easier to prove than the other three.

Finally, the fifth requirement, “reasonably equivalent to the value or interest received” can be satisfied by looking at the value of the shares. For the most part, the value of the debtor’s shares will be zero or minimal. The shares are typically encumbered with priority debt. In other words, there is no market for the shares because no one would be willing to purchase the encumbered shares other than the individual who controls or operates the debtor. Thus, what is being purchased from the new money or money’s worth is no more than the right to control the debtor, which has no net asset value. Therefore, the fifth requirement is satisfied.

In addition to the above requirements, the Supreme Court has emphasized that there must be a market test before the new value will pass the new value exception. The Supreme Court has found that the “absolute priority rule” is violated when a plan “provision [vests] 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.”  Bank of Am Nat'l Trust & Sav Ass'n v 203 N Lasalle St P'ship, 526 US 434, 437; 119 S Ct 1411; 143 L Ed 2d 607, 612 (1999) (emphasis added). In LaSalle, “no one else could propose an alternative” plan, “the Debtor's partners necessarily enjoyed an exclusive opportunity that was in no economic sense distinguishable from the advantage of the exclusively entitled offeror or option holder.” Bank of Am Nat'l Trust & Sav Ass'n v 203 N Lasalle St P'ship, 526 US 434, 455; 119 S Ct 1411; 143 L Ed 2d 607, 623 (1999). However, this element may be satisfied where no else has proposed a competing reorganization plan. In other words, the creditor who is objecting to the cram down should propose a competing reorganization plan otherwise the debtor may be able to satisfy the new value exception and avoid the absolute priority rule. 

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