One of the fundamental goals of a chapter 11 bankruptcy is the maximization of value available for distribution to creditors. The "absolute priority rule" generally applicable in chapter 11 requires that each class of impaired and unaccepting creditors be paid in full before any junior class of claims or interests may receive distributions under the plan. Courts recognize a limited exception to the absolute priority rule, however, allowing prepetition shareholders to retain their interest in the debtor where they contribute new value toward the debtor's reorganization. In In re Cleary Packaging, LLC, 2023 WL 8703920 (Bankr. D. Md. 2023), the U.S. Bankruptcy Court for the District of Maryland analyzed this "new value exception" to the absolute priority rule in denying confirmation of the debtor's proposed chapter 11 plan.
In Cleary Packaging, a chapter 11 debtor proposed in its plan that its sole owner would retain 100% ownership of the debtor while contributing funds that would provide only a fractional distribution to creditors over a 60-month period. The bankruptcy court closely scrutinized the various forms of the owner's proposed contributions to determine whether they were sufficiently substantial in the aggregate to justify his continued ownership of the reorganized entity. Acknowledging the merit of the new value exception in certain situations, the court nevertheless held that the requirements of the exception were not satisfied in the case before it.
Chapter 11 Plan Confirmation
A primary goal of any chapter 11 case is the successful confirmation and implementation of a plan of reorganization. Pursuant to section 1123 of the Bankruptcy Code, in order to be confirmed, the plan must: (i) classify claims; (ii) specify the treatment of each class and whether they are impaired; and (iii) provide the same treatment for claims of each respective class, unless the holder of a particular claim or interest agrees to less-favorable treatment.
Bankruptcy Code section 1123 requires that a plan specify any class of claims that is not "impaired." A class of claims is unimpaired where "the legal, equitable and contractual rights of the holders of such claims or interests are unaltered by the plan." Collier on Bankruptcy ¶ 1123.01[2] (16th ed. 2023). Impaired classes may vote on whether to accept or reject a plan of reorganization. A class of claims accepts the plan if it is accepted by at least two-thirds in amount and more than one-half in number of the allowed claims of a class. 11 U.S.C. § 1126(c).
Bankruptcy courts evaluate the classification and treatment of claims under a proposed plan to ensure conformity with the statutory requirements. Section 1129(a) of the Bankruptcy Code requires certain criteria be met for confirmation of a plan of reorganization. Under that provision, a bankruptcy plan may be confirmed if either: (i) no classes of creditors are impaired; or (ii) all impaired classes vote to accept the plan. Under section 1129(b), however, confirmation is permitted despite rejection of the plan by one or more impaired classes if certain "cram-down" requirements are met. In particular, the court must find that the plan is "fair and equitable" and "does not discriminate unfairly" against any dissenting class. 11 U.S.C. § 1129(b)(1).
The Absolute Priority Rule and the New Value Exception
For a chapter 11 plan to be "fair and equitable" with respect to a dissenting impaired class of unsecured creditors, the Bankruptcy Code requires that the creditors in the class be paid in full or, failing full payment, no creditor of lesser priority, or shareholder, receive any distribution under the plan. This central tenet of bankruptcy law, sometimes referred to as the "absolute priority rule," predates the Bankruptcy Code and was first articulated by the U.S. Supreme Court in 1913 in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913).
In Case v. Los Angeles Lumber Products Co., 308 U.S. 106 (1939), the Supreme Court crafted a "new value exception" to the absolute priority rule applicable in cases under the former Bankruptcy Act. In that case, the Court held that a junior stakeholder's continued ownership in an insolvent company pursuant to a plan of reorganization, over the objection of a senior impaired creditor, may be appropriate upon a contribution of new money by the junior stakeholder.
The Supreme Court has rarely addressed this new value exception to the absolute priority rule since enactment of the Bankruptcy Code in 1978. In Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988), the Court held that, even if the new value exception survived enactment of the Code, the new value requirement could not be satisfied by promised future contributions of labor. Additionally, the Court has declined to explicitly adopt or condemn a "new value exception" even in the rare instances that it has addressed the issue.
For example, the Court did not vacate on appeal the Ninth Circuit's Bonner Mall opinion, which held that the new value exception survived enactment of the Bankruptcy Code. See U.S. Bancorp Mortg. Co. v. Bonner Mall P'ship, 513 U.S. 18, 19 (1994). And in 1999, the Court declined to overrule the Seventh Circuit's acceptance of the new value exception. See Bank of Am. Nat. Tr. & Sav. Ass'n v. 203 N. LaSalle St. P'ship, 526 U.S. 434 (1999). Instead, the Court assumed for purposes of its ruling that the exception was available and held that one or more of the five elements nevertheless were not satisfied when old equity retained the exclusive right to contribute the new value―i.e., without a "market test."
Bankruptcy courts have disagreed on the effect of the enactment of the Bankruptcy Code on the "new value exception" that the Supreme Court defined in Case.Some courts, including the Fourth and Ninth Circuit Courts, permit the exception and will use a five-factor test to evaluate the proposed new value. The factors require the value to be: "(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." See In re Brotby, 303 B.R. 177, 195 (9th Cir. BAP 2003); In re Juarez, 603 B.R. 610, 622 (9th Cir. BAP 2019); In re Crowe, 2021 WL 2212005, at *12 (Bankr. D. Ariz. 2021). In addition, the Seventh Circuit ruled that the new value exception requires that there be a competitive bidding process for new equity, and other stakeholders must be provided the opportunity to propose competing plans. See In the Matter of Castleton Plaza, LP, 707 F.3d 821 (7th Cir. 2013).
Subchapter V's Limited Exception to the Absolute Priority Rule
The Small Business Reorganization Act of 2019 added subchapter V to chapter 11 of the Bankruptcy Code. Pub. L. 116-54, 133 Stat 1079 (Aug. 23, 2019) (H.R. 3311). Subchapter V provides a path for "small business debtors," as defined in in section 101(51D) of the Bankruptcy Code, to reorganize. Debtors who elect to proceed under subchapter V are able to avoid the absolute priority rule, because the subchapter specifically contemplates the provision of other creditor protections. Although subchapter V provides that a nonconsensual plan must not discriminate unfairly and be fair and equitable with respect to dissenting classes, the definition of "fair and equitable" in subchapter V does not include the absolute priority rule.See 11 U.S.C. §§ 1181(a) and 1191.
Cleary Packaging
In Cleary Packaging, the bankruptcy court discussed the attempts by an owner of a small business debtor to confirm a chapter 11 plan and retain his interest notwithstanding the absolute priority rule. Cleary Packaging, LLC (the "Debtor") is a company in the packaging industry. Vincent Cleary (the "Owner") is the Debtor's founder and owner. Cantwell-Cleary Co., Inc. (the "Judgment Creditor") is a competitor owned by other members of the Owner's family. The Owner previously worked for the Judgment Creditor, leaving to form the Debtor, and multiple employees and clients accompanied him. Unable to successfully compete with the Debtor, the Judgment Creditor brought suit in state court for tortious interference with business relations and obtained a judgment against the Debtor in the amount of almost $5 million.
Although the Debtor's business was otherwise relatively successful, it was forced to file for bankruptcy relief in the District of Maryland under the weight of the substantial state court judgment. Initially, the Debtor elected to proceed as a small business debtor under subchapter V. The Judgment Creditor opposed that designation, arguing that, under section 1192(2) of the Bankruptcy Code, debts arising from "willful and malicious injury"—as defined in section 523(a)—are not dischargeable in subchapter V.
The Debtor countered that this specific exception to discharge under section 523(a) applies only to individual debtors. Although the bankruptcy court agreed with the Debtor, the Fourth Circuit ultimately reversed, holding that the discharge exceptions of subchapter V of chapter 11 apply to individuals and corporate debtors alike. See In re Cleary Packaging, LLC, 36 F. 4th 509 (4th Cir. 2022). The Debtor therefore removed the subchapter V designation and proceeded with a traditional chapter 11 case. Subsequently, both the Debtor and Judgment Creditor filed competing plans of reorganization.
Under the Debtor's plan, there were two classes of unsecured creditors. Class 4 contained general unsecured creditors, while class 5 consisted of the Judgment Creditor's claim. Although the Judgment Creditor challenged the Debtor's classification of claims, the court ultimately was not required to rule on that issue. Generally, under the plan, the Debtor proposed to make payments to unsecured creditors for 60 months. The amount of the payments was to be established by the Debtor's projected disposable income. The Owner would retain his equity in the Debtor in exchange for his contribution of certain alleged new value.
The Owner's proposed new value consisted of "(i) his sweat equity [in the reorganized Debtor]; (ii) the payment or debt forgiveness on his prepetition claim against the Debtor (arguably approximately $2,000 in wages and $47,000 in commissions); (iii) his $35,000 postpetition (and preconfirmation) loan to the Debtor; and (iv) $25,000 (presumably in cash) from his retirement account." See In re Cleary Packaging, 2023 WL 8703920, at *16. The Debtor argued that these contributions allowed him to retain his ownership interest under the new value exception, in part because his equity interest was worthless, so any value he provided would be at least equivalent to the value of that interest.
The Judgment Creditor's competing plan proposed that the Judgment Creditor would purchase the Debtor's equity for $250,000, after which it would continue operating the business to repay unsecured creditors. The Judgment Creditor's plan relied upon continued operations of the Debtor for nine years. Although repayments would include the state court judgment, that claim would be subordinated to the claims of other creditors. The plan did not clearly provide how the reorganized business would operate or retain necessary employees.
The Debtor's other creditors preferred the Debtor's plan and voted to accept it. Only the Judgment Creditor voted to accept its plan. The bankruptcy court considered the evidence in support of confirmation of each plan at a consolidated confirmation holding.
The Bankruptcy Court's Ruling
The bankruptcy court denied confirmation of both plans of reorganization. Balancing the need for maximum value to creditors with the feasibility of reorganization, U.S. Bankruptcy Judge Michelle Harner held that neither plan met the statutory requirements of section 1129 of the Bankruptcy Code.
At the outset of her discussion, Judge Harner explained that the court need not decide whether a "market test" of value is always required for the new value exception to apply. Instead, she noted, "[a] market test may be necessary in certain cases if a debtor is not able to demonstrate new, substantial, and equivalent value through other admissible evidence." Id. at *14. In this case, however, the bankruptcy court explained that it had both the Debtor's evidence on new value and a competing bid/plan from the Judgment Creditor. It concluded that it need consider only the former to resolve the issue.
The Debtor's Plan.According to Judge Harner, the Debtor's plan failed because it violated the absolute priority rule and, thus, the fair and equitable requirement of section 1129(b). The court recognized that two practical "approaches have emerged to address the dilemma posed to prepetition equity holders of a chapter 11 debtor." Id.at *14. Those approaches consist of the express provisions of subchapter V and the judicially defined new value exception. Id.
The bankruptcy court focused initially on the value of the Owner's equity in the Debtor, to which the alleged new value must be reasonably equivalent. On that issue, the court disagreed with the Owner that its equity was worthless. To the contrary, based on the Debtor's demonstrated history of profitability combined with the apparent business capabilities of the Owner, the court found that the evidence established that the Owner's equity had at least some value.
Judge Harner then evaluated each form of the Debtor's proposed new value under the five-factor test stated in Bonner Mall. The court swiftly rejected the Owner's offers of "sweat equity" and "debt forgiveness" as potential new value. Citing cases, including the Supreme Court's decision in Northwest Bank Worthington, the court noted that such forms of proposed new value "are not considered 'new,' 'substantial,' or 'money or money's worth.'" Id.at *17. The court also found that the Owner's third proposed form of new value, a $35,000 postpetition and preconfirmation loan, was neither "new" nor "money or money's worth" under the test.
The court concluded that only the Owner's proposed contribution of $25,000 from his retirement account qualified as potential new value. Avoiding the "time consuming determination as to whether the new value contribution is reasonably equivalent to the value being received [the equivalence prong]," the court determined that the proffered new value failed the threshold requirement that it be "substantial." In this regard, the court found that the proposed new value "pale[d] in comparison to the total amount of claims in this case, the total amount of proposed distributions to creditors under the Debtor's Plan, and the percentage of creditor recovery in the case." Id. at *18. Specifically, the amount of the new value represented less than 0.5% of the approximately $5 million of claims in the case and only approximately 1.8% of the $1.38 million proposed to be distributed to creditors, providing them with a recovery of only 27%, while the Owner would retain 100% of his interest. The Owner's proposed new value thus failed to satisfy the substantiality prong of the applicable test, and the court accordingly ruled that the Debtor's plan could not be confirmed because it violated the absolute priority rule.
The Judgment Creditor's Plan.The Judgment Creditor's plan also failed. Because the plan did not provide a definite strategy for the operations or structure of the reorganized entity, the bankruptcy court found that the plan lacked adequate means of implementation demonstrating feasibility. For example, the Debtor's prepetition success was largely due to the Owner's business prowess and the loyalty of his employees. The Judgment Creditor's plan did not explain how the Debtor would be run effectively and retain employees without the Owner's involvement. Instead, it merely provided potential options for how the Debtor might continue after confirmation without actually addressing these issues.
Outlook
Bankruptcy courts are not uniform in their acceptance of application of the new value exception to the absolute priority rule. Cleary Packaging recognizes the exception but provides an example of the high bar necessary to satisfy its requirements. Moreover, the requirement that proposed new value be substantial in and of itself—in addition to reasonably equivalent to the interest retained—may provide objecting parties with effective grounds to challenge asserted new value without engaging in complex and potentially costly valuation litigation.
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