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The absolute priority rule ordinarily prevents a Chapter 11 debtor from distributing any money or property to junior creditors and old equity investors unless all senior creditors have first been paid in full. See 11 U.S.C. § 1129(b)(2)(B)(ii). Nevertheless, old equity investors may attempt to receive new equity in the reorganized debtor in consideration for providing new (post-bankruptcy) investments in the debtor. Such “new value” plans are sometimes permitted on the theory that the investors are receiving a distribution from the debtor in exchange for their new contribution, not on account of their old equity interests, and thus there is no violation of the absolute priority rule. The Supreme Court in Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434, 119 S.Ct. 1411 (1999), held that any new value plan must be market tested to ensure that the plan provides the best recovery to all creditors and does not unfairly advantage existing equity holders. Courts have usually interpreted the market test requirement to mandate a competitive bankruptcy auction or the termination of the debtor’s exclusivity period to file and solicit acceptance of a reorganization plan so that the would-be plan sponsors and parties-in-interest may file their own competing plans.

In In re Castleton Plaza, LP, 2013 WL 537269 (7th Cir. Feb. 14, 2013), the Seventh Circuit, as the first circuit court to address the issue in the context of an insider, extended 203 North LaSalle a step further and held that “[c][/c]ompetition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider.”

In re Loop 76, LLC, 465 B.R. 525 (B.A.P. 9th Cir. 5/2012)A “cramdown” plan of reorganization in a Chapter 11 commercial real estate case typically involves an attempt by a property owner to force an undersecured mortgage lender to accept a “new note” for a reduced principal amount, equivalent to the value of the mortgaged property, with modified terms including an extended maturity and a “market” rate of interest. As explained in more detail below, mortgage lenders, which are often the overwhelmingly largest creditor in these cases, have been relatively successful in blocking these plans by using their deficiency claim to control the unsecured creditor class and cause it to vote against plan approval. If a debtor cannot get approval of a plan of reorganization, the case will typically be dismissed and the mortgage lender will be able to exercise its right to foreclose under applicable state law.

In a recent decision, In re Loop 76, LLC, 465 B.R. 525 (B.A.P. 9th Cir. 2012), the Bankruptcy Appellate Panel of the Ninth Circuit upheld a Bankruptcy Court determination that a secured lender’s unsecured deficiency claim could be separately classified from the claims of other unsecured creditors, paving the way for confirmation of a cramdown plan of reorganization over the lender’s opposition. Rejecting the lender’s argument that its borrower – a single asset real estate debtor – had “gerrymandered” an accepting impaired class in order to confirm its plan, the court focused on the lender’s access to third-party guarantees to support an evidentiary conclusion that its claim was not “substantially similar” to other unsecured creditors, such that separate classification was appropriate without any inquiry into the debtor’s motivation for doing so.

Because guarantees of some sort are relatively common in real estate finance (including guarantees that take effect upon the filing of an owner bankruptcy), this decision has ramifications for many lenders, particularly where their borrower is able to file bankruptcy within the Ninth Circuit. In addition, the court’s method—assessing the similarity of the claims not strictly based on their respective right and priority to the debtor’s assets, but in light of other circumstances affecting the holders of those claims—opens the door to a potentially wide variety of factual arguments for separate classification.

Imagine that the debt is $200,000 and that it is secured by a first lien on real property worth $150,000. If the undersecured creditor does not make the section 1111(b)(2) election, you can strip the lien down to the $150,000 value of the real property and pay that $150,000 off with interest over whatever period of time the court will allow (probably at least fifteen years, I’d think, but it may depend on the condition of the collateral and on the expected financial stability of the reorganized debtor). Assuming you use 1129(b)(2)(A)(i), the plan will have to let the creditor retain its lien on the property for the amount of the allowed secured claim ($150,000), will have to provide for cash payments over time that have a present value as of the effective date of the plan equal to the value of the lien ($150,000) (which means you will have to provide for payment of the $150,000 with interest over a period of time), and will have to provide for cash payments (including both principal and interest) that total at least $150,000 (which will obviously be satisfied because there is no way, if you don’t have a time machine, to make payments with a present value of $150,000 without paying at least 150,000 total dollars of principal and interest).

The language of (b)(2)(A)(i) is complex due to the possibility that the undersecured creditor will make the section 1111(b)(2) election.

If the unsecured creditor makes the section 1111(b)(2) election then you have to let the creditor keep a lien for the entire amount of its $200,000 debt (because the whole $200,000 will be treated as an allowed secured claim), and you have to provide for the total of all the payments to be at least $200,000 (because the allowed secured claim will be $200,000), but the present value of the payments need not be more than $150,000 (because that continues to be the value of the lien — a lien cannot be worth more than the value of the collateral, and thus the making of the section 1111(b)(2) election does not increase the value of the lien). Interest payments made under the modified mortgage are permitted to count toward the $200,000 in total cash payments. Thus, as long as the court will let you make payments over a long enough time period, you can meet the $200,000 total payment requirement without having to pay more than $150,000 in present value. That means the making of the election usually does not require you to provide larger payments in the plan. But if the reorganized debtor then wants to refinance or to sell the property free and clear in the next several years, the secured creditor can block the sale or refinancing unless it is paid the remaining amount that is not yet paid of the $200,000. That gives the secured creditor leverage to extract a payment in exchange for releasing its lien.

In re: Midpoint Dev., L.L.C. (10/31/06 – No. 05-6046) (10th Cir. Ct. Apps) Dismissal of a debtor’s Chapter 11 bankruptcy petition is affirmed where the district court correctly concluded that the debtor had ceased to legally exist prior to its bankruptcy filing, and that thus, its bankruptcy filing was a nullity and subject to dismissal.

IN Re: Debbie Reynolds Hotel & Casino, Inc.. (07/06/01 – No. 99-17240) (9th Cir. Ct App) Bankruptcy Code Section 506(c), which limits standing to challenge a settlement agreement to the trustee or Chapter 11 debtors-in-possession, applies retroactively.

IN RE: Circle K Corp. (12/05/01 – No. 00-15361) (9th Cir. Ct App) A professional’s application for services in a Chapter 11 proceeding must unambiguously seek pre-approval under 11 USC 328 or it will be subject to reasonableness review under 11 USC 330, although a bankruptcy court’s failure to specify will not preclude review under section 328.