Under the so-called "new value exception" to the absolute priority rule,¹ the debtor’s "existing equity" may retain its ownership interests in the debtor provided that it contributes "new value" to the debtor where that 1) the capital contribution by the existing equity is new, 2) the contribution is substantial, 3) the contribution is in the form of money or money’s worth (i.e., not future services, etc.), 4) the contribution is necessary for a successful plan of reorganization, and 5) the contribution is reasonably equivalent to the value of the interest to be retained by the existing equity. See Coltex Loop Central Three Partners L.P. v. BT/SAP Pool C Associates, L.P., No. 96-5140, 1998 WL 90844 (2d Cir. Feb. 19, 1998). See, also, Bonner Mall Partnership v. U.S. Bancorp Mortgage Co. (In re Bonner Mall Partnership), 2 F.3d 899 (9th Cir. 1993), cert. granted, 510 U.S. 1039 (1994), motion to vacate denied, 513 U.S. 18 (1994).

Although the continued vitality of the new value exception remains uncertain, even those courts that adopt the exception often disagree on its application. For example, the U.S. Court of Appeals for the Second Circuit recently addressed the new value exception in Coltex Loop Central Three Partners L.P., supra. In Coltex, the debtor’s primary asset was an office building that the debtor valued at $2.95 million, but which BT/SAP, the debtor’s primary secured creditor, valued at $5.7 million. (The debtor and BT/SAP stipulated that BT/SAP’s total claim was $7.2 million). The debtor’s schedules listed other general unsecured claims of approximately $123,000. The debtor’s proposed plan of reorganization provided, among other things, that (a) the unsecured claims (including BT/SAP’s unsecured deficiency claim) would be paid 10 percent of the allowed amount of the claim in cash, and (b) the debtor’s existing equity would retain its existing equity interests in consideration of the equity’s funding of the plan with approximately $3.4 million.

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...the Coltex court managed to open the door slightly for other courts to apply the new value exception without the necessity of competitive bidding.

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After the bankruptcy court confirmed the Coltex debtor’s plan of reorganization over the objections of BT/SAP, the district court reversed and found the plan unconfirmable because the debtor failed to establish that the existing equity’s "new value" was "necessary" inasmuch as other avenues for funding the plan had not been fully explored. On appeal, the Second Circuit affirmed the decision of the district court. In so ruling, the Second Circuit concluded that, in certain circumstances, a new value plan cannot be confirmed unless the debtor’s assets are subjected to market bids.²

In Coltex, the Second Circuit essentially relied on two factors in determining that the debtor’s plan could not be confirmed due to a lack of competitive bidding. First, the Second Circuit stressed that BT/SAP had previously attempted (albeit unsuccessfully) to shorten the debtor’s exclusivity period so that BT/SAP could submit its own plan. Second, the court also stressed that BT/SAP’s contemplated plan proposed to pay non-insider unsecured creditors in full (as opposed to the 10 percent distribution provided in the debtor’s plan). The Second Circuit emphasized the importance of these two factors by stating as follows:

Based on the facts of this case, it is apparent that [existing equity] could not have gained their new position but for their prior equity position. In this case, BT/SAP was ready with a plan of its own, which proposed to pay non-insider unsecured creditors in full. It would have left [existing equity] with nothing. They, like anyone else, could have attempted to purchase the property at market price. Instead, under the plan, [existing equity] avoid foreclosure by BT/SAP and obtained the property at a set price untested by market forces, leaving the unsecured creditors with a 10 percent recovery. Common sense suggests that [existing equity] believe that they are getting a bargain by virtue of their previous position, which enables them to avoid both competing reorga-nization plans and competing bids for the property. (footnotes omitted).

Id. at *6. The Second Circuit further explained:

This was an insider’s plan for the benefit of insiders. It was of little benefit to any creditor, and the major creditor was stymied in its legitimate attempts to obtain the value of its claims. The plan was not fair and equitable.

Id. at *8.

Despite the potentially broad application of the Coltex court’s holding with respect to an apparent requirement for competitive bidding, the Coltex court managed to open the door slightly for other courts to apply the new value exception without the necessity of competitive bidding. Specifically, the Second Circuit stated "[w]here no other party seeks to file a plan or where the market for the property is adequately tested, old equity may be able to demonstrate that it can meet the requirements of 11 U.S.C. §1129 and that, in essence, it receives nothing on account of its prior position" (emphasis supplied).

The Second Circuit’s desire to prevent the perceived unfairness of an insider taking advantage of the debtor’s unsecured creditors is understandable. The "com-petitive bidding" requirement adopted by the Second Circuit may, however, result in an unforeseen shift in leverage as between a debtor and its creditors, thereby resulting in potentially far reaching consequences in the plan negotiation process. For example, a debtor’s existing equity, faced with the often complex and time-consuming task of formulating a confirmable chapter 11 plan, may have less of an incentive to expend the necessary time and resources to formulate and propose a plan if a creditor can simply sit on the sidelines and expend little or no resources until the competitive bidding phase, at which time it may be able to out-bid the debtor’s existing equity. Within the constraints of a debtor’s fiduciary duties to its creditors, a debtor should be given the opportunity to control its own fate by proposing a plan that provides for existing equity to retain ownership of the debtor. Only if the bankruptcy court determines that exclusivity should be terminated should a creditor be permitted to exert leverage by proposing a plan that provides for third party ownership of the debtor.

The potential fallacy with competitive bidding is the implicit assumption that competitive bidding will always generate the highest value for creditors. For example, assume that existing equity proposes a new value plan with a "competitive bidding" provision to satisfy a particular court’s interpretation of the new value exception. Further assume that existing equity determines that it would be willing to invest up to $1 million in "new value" in order to retain its equity interest. Inasmuch as the proposal of existing equity will be subjected to market bids, most rational holders of equity interests would "low ball" their proposed new value contribution in the hope that few other parties actually bid, thereby enabling existing equity to be the successful bidder for substantially less than the $1 million it would have otherwise been willing to contribute. Conversely, if competitive bidding was not required, existing equity may be more likely to contribute closer to the value that it attributes to its existing equity interest in the belief that the bankruptcy court (with the assistance of appraisers, etc.), and not simply "market forces," will determine the reasonableness of the contribution.

While it can be argued that the bankruptcy court’s review of the rea-sonableness of the contribution will not prevent existing equity from submitting a plan that is "unfair" to creditors, existing equity assumes a greater risk. Specifically, if a bankruptcy court were to determine that existing equity’s contribution was not sufficient, then the court would likely deny confirmation and terminate exclusivity, thereby reducing existing equity’s control over the plan process. On the other hand, if a bankruptcy court only relied on competitive bidding to determine the sufficiency of the new value, existing equity would simply continue to bid higher in an attempt to out-bid third parties. As a result, there would be no real "down side" for existing equity to "low ball" its new value bid.

With the existing conflict between the various courts regarding not only the existence of the new value exception but also the elements of a confirmable new value plan, it can only be a matter of time before the Supreme Court rules on these issues.³

Footnotes

¹The absolute priority rule provides that the holder of any junior claim or interest may not "receive or retain [any property] under the plan on account of" such junior claim or interest unless all senior classes of creditors either consent to the confirmation of the plan or receive the full allowed amount of their claims. 11 U.S.C. §1129(b). Return to Text

² Although the Coltex court based its holding primarily on the lack of competitive bidding, the court also stated that "even if we were to rely on the traditional framework for evaluating new value exceptions to the absolute priority rule, we would reach the same result." Specifically, the court concluded that the debtor failed to show that the contribution from existing equity was necessary for a successful plan of reorganization. Return to Text