A Strategy to Beat the Absolute Priority Rule in Family Business Bankruptcies

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A strategy (photo by Marilyn Swanson)

By: Donald L. Swanson

The absolute priority rule is the greatest legal impediment to reorganizing a family business under Chapter 11—no other legal impediment is even close.

In what follows, I offer a strategy for beating that rule.

The Absolute Priority Rule

The absolute priority rule is a Chapter 11 plan confirmation requirement. It says: if debtor’s owners want to retain anything after confirmation, unsecured creditors must either be paid in full or agree to something less. [Fn. 1]

I experienced the entirety of the 1980s Farm Crisis as a young bankruptcy attorney. And here’s what I saw: owners would not give up their ownership interests voluntarily, and creditors would rarely (if ever) agree to take less than 100%. As a result, farmer Chapter 11 plans could not be confirmed. Because of that reality, Congress enacted Chapter 12.

A Strategy that Beats the Absolute Priority Rule

Back in the early 1990s, I came up with a strategy to beat the absolute priority rule. The strategy is this:

Providing a post-confirmation auction sale of ownership interests in the reorganized debtor.

Ok . . . I know that sounds bizarre. But it works.

A Corporate Example

Here’s how it came about.

A family business filed Chapter 11 in the early 1990s. Dad had built the business and incurred lots of debt from individual investors. Then, Dad died. Son took his place but did not have Dad’s business or people skills.

Early in the case, debtor’s counsel developed a conflict and resigned. I stepped in to represent debtor.

The first Court appearance I made was a day-long trial on motions to dismiss or convert, based on Son’s alleged bad acts. Investors who hated Son [that’s not an exaggeration] filled the courtroom. We barely survived, and the Judge said I’d better get a confirmable plan on file soon.

—The Solution

Having experienced, first-hand, absolute priority rule problems througout the prior decade, I racked my brain for a solution. Here’s what I came up with—a plan provision that says:

  • Upon confirmation, all ownership interests in the debtor are cancelled;
  • Immediately after confirmation, a public auction will be held in the courtroom—what’s up for sale is 100% of the ownership interests in the reorganized debtor;
  • The successful bidder will become owner of the reorganized debtor, with all its assets and debts; and
  • Mom [who had no personal liability for debtor’s debts] is making an opening auction bid of $XX [a relatively small sum], and anyone else can make a competing bid.

—The Results

The Court confirmed the plan, despite the absolute priority rule. The auction occurred. No one else bid. Mom paid her bid amount, using money from Dad’s life insurance policy, and became 100% owner of the reorganized debtor.

In other words, it worked!

—Why It Worked

Here’s why it worked:

  • The absolute priority rule says an owner cannot “receive or retain . . . any property”; and
  • By subjecting ownership interests to a public auction, the family is repurchasing the ownership interests at market value, not receiving or retaining anything.

There are, obviously, practical risks and uncertainties for the family in this strategy—and it won’t work for every family business. But it worked in this case.

An Individual Case

The strategy works for individual debtors as well.

In an individual Chapter 11 with $10 million of debt, for example, we achieved a confirmed plan using the following provisions that beat the absolute priority rule:

  • Upon confirmation, debtor’s ownership interests are cancelled;
  • Immediately after confirmation, ownership interests in the reorganized debtor will be auctioned;
  • A family member, who has no liability for debtor’s debts, will provide a gift of $XX [a relatively small amount] to debtor to make the opening auction bid;
  • Anyone else can make a competing bid, provided they give notice of an intent to do so at least 10 days before the confirmation hearing; and
  • The successful bidder will become the owner of the reorganized debtor, with all its assets and debts.

In this individual case, no one else bid, and debtor became 100% owner of the reorganized debtor.

The strategy worked!

A Disclaimer

Granted, in each of the two cases discussed above, plans were confirmed with creditors voting in favor of confirmation—we had no negative vote in either case, despite significant hostility.

But those approving votes occurred, in part, because of the strategy utilized in both cases to beat the absolute priority rule.

Keeping a Family Business Out of Bankruptcy

The strategy has even worked to keep a family business out of bankruptcy. Here’s how:

I represented a family business in negotiations with its primary secured creditor;

I sent the draft of a proposed bankruptcy plan to the creditor’s attorney, which contained the same types of provisions described above for beating the absolute priority rule;

Regarding the absolute priority strategy, creditor’s attorney said, “That will never work!” To which I responded, “Why not?” He had no answer, so I named the date we’d be filing Chapter 11; and

On the specified filing date, he called with an offer we couldn’t refuse—we accepted the offer, avoided bankruptcy, and the debtor is thriving to this day.

Conclusion

The strategy described above for beating the absolute priority rule can be an essential tool for representing family businesses, effectively, in Chapter 11.

—————————————————-

Footnote 1: 11 U.S.C. § 1129(b)(2)(B) says in part:

(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, . . .

** If you find this article of value, please feel free to share. If you’d like to discuss, let me know.

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