By: Donald L Swanson
The absolute priority rule [Fn. 1] has been a problem for businesses in bankruptcy—for a very long time! The rule dates back to at least 1899, when the U.S. Supreme Court prevents certain shareholder actions “until the interests of unsecured creditors have been preserved.” [Fn. 2]
Since then, the U.S. Supreme Court has followed a long and relatively straight road for the absolute priority rule. And the rule has shown staying power, along that road.
Congress minimizes the effect of the rule in recent times by enacting Subchapter V with its $7.5 million eligibility limit and by increasing Chapter 12’s eligibility limit to $10 million.
But the absolute priority rule still governs Chapter 11 proceedings of businesses who can’t qualify for Subchapter V or Chapter 11.
And the absolute priority rule rule governs in individual Chapter 11 cases as well, according to a September 8, 2023, opinion by the Southern Florida Bankruptcy Court (In re Joseffy) that declares:
- all of the five circuit courts of appeal that have considered the issue hold that the absolute priority rule applies in individual Chapter 11 cases; and
- that means, “individual debtors may retain their exempt property” without violating the rule but may not “retain non-exempt property.”
So, this article is intended as a refresher on the U.S. Supreme Court’s two primary cases on the Bankruptcy Code’s absolute priority rule.
Holdings in two Supreme Court Cases
In Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988), the opening paragraph of the Supreme Court’s opinion says:
“In this case, the Court of Appeals found that respondents’ promise of future ‘labor, experience, and expertise’ permitted confirmation of their Chapter 11 reorganization plan over the objections of their creditors, even though the plan violated the ‘absolute priority rule’ of the Bankruptcy Code. Because we find this conclusion at odds with the Code and our cases, we reverse.”
In Bank of America National Trust and Savings Assn. v. 203 North LaSalle Street Partnership,526 U.S. 434 (1999), the opening paragraph of the Supreme Court’s opinion says:
“The issue in this Chapter 11 reorganization case is whether a debtor’s prebankruptcy equity holders may, over the objection of a senior class of impaired creditors, contribute new capital and receive ownership interests in the reorganized entity, when that opportunity is given exclusively to the old equity holders under a plan adopted without consideration of alternatives. We hold that old equity holders are disqualified from participating in such a ‘new value’ transaction by the terms of 11 U. S. C. § 1129(b)(2)(B)(ii), which in such circumstances bars a junior interest holder’s receipt of any property on account of his prior interest.”
And the closing paragraph of 203 North LaSalle says:
“Whether a market test would require an opportunity to offer competing plans or would be satisfied by a right to bid for the same interest sought by old equity is a question we do not decide here. It is enough to say . . . that plans providing junior interest holders with exclusive opportunities free from competition and without benefit of market valuation fall within the prohibition of § 1129(b)(2)(B)(ii).”
What follows is a summary of each of these two opinons.
Norwest Bank v. Ahlers:
—Ahlers Facts
Ahlers operate a failing family farm in Nobles County, Minnesota. Between 1965 and 1984, they obtain loans from Norwest Bank, secured by their farmland, machinery, crops, livestock, and farm proceeds.
In November, 1984, Ahlers default on such loans, with total debts to Norwest Bank exceeding $1 million.
—Ahlers Litigation
Norwest Bank files a replevin action to recover possession of Ahlers’s farm equipment. In response, Ahlers file Chapter 11.
Norwest Bank seeks relief from the automatic stay. Ahlers defend with proposed terms of a reorganization plan, but the Bankruptcy Court grants relief from stay. After appeals, the District Court finds Ahlers’s proposed reorganization plan to be “utterly infeasible” and affirms the relief from stay order.
—Ahlers at Court of Appeals
The Court of Appeals reverses, finding that Ahlers could file a feasible reorganization plan, and remands with instructions to confirm Ahlers’s proposed plan. The Court of Appeals holds, in a “sharply divided” opinion:
- the absolute priority rule does not apply because Ahlers contributed “money or money’s worth” to the reorganized enterprise; and
- Ahlers’s “yearly contributions of labor, experience, and expertise” would constitute a contribution of “money or money’s worth,” permitting plan confirmation over Norwest Bank’s objections.
—Ahlers at Supreme Court
The U.S. Supreme Court grants certiorari “to consider the Court of Appeals’ application of the absolute priority rule.”
The Supreme Court reverses. Here is its rationale.
The Rule. The absolute priority rule requires that a dissenting class of unsecured creditors be paid in full before any junior class can receive or retain any property under a plan.
The rule began, under early bankruptcy statutes, as a judicial construction of the undefined requirement that reorganization plans be “fair and equitable.”
The rule has since gained express statutory force. See 11 U.S.C. § 1129(b)(2)(B)(ii). Under current law, no Chapter 11 reorganization plan can be confirmed over legitimate creditor objections, unless it complies with the absolute priority rule.
Primary Ruling. “There is little doubt that a reorganization plan in which [Ahlers] retain an equity interest in the farm is contrary to the absolute priority rule.”
The Court of Appeals wrongly utilized an “exception” or “modification” to the absolute priority rule. It relied on Case v. Los Angeles Lumber Products Co., 308 U.S. 106 (1939), in concluding that Ahlers’s future contributions of “labor, experience, and expertise” in running the farm get around the absolute priority rule because such contributions have “value” and are “measurable” — are “money or money’s worth.”
The error is this: Case v. Los Angeles Lumber, itself, specifically rejects an analogous proposition.
And the reality is this: Ahlers’s promise of future services is intangible, inalienable, unenforceable, and “has no place in the asset column of the balance sheet” of the new entity.
Additional Ruling. Ahlers also argue to the Supreme Court that, because the farm has no “going concern” value (apart from their own labor on it), any equity interest they retain in a reorganization of the farm is worthless, and therefore is not “property” under 11 U.S.C. § 1129(b)(2)(B)(ii).
The Supreme Court rejects this “no value” argument because a debtor who retains ownership retains “property,” regardless of values involved.
Special Equities. In rejecting Ahlers’s position, the Supreme Court notes that it considered the special equities of the situation:
- “Farm bankruptcies are in a state of crisis and we, too, sympathize with the plight of the American farmer. Nevertheless, the solution proposed by the Ahlers majority is contrary to the Bankruptcy Code and a long line of case law”; and
- “Relief from current farm woes cannot come from a misconstruction of the applicable bankruptcy laws, but rather, only from action by Congress.”
Bank of America v. 203 North LaSalle
—North LaSalle Facts
Bank of America (“Bank”) is the major creditor of 203 North LaSalle (“Debtor”).
Bank lends Debtor $93 million, secured by a first mortgage on Debtor’s principal asset: 15 floors of an office building in downtown Chicago.
In January 1995, Debtor defaults, and Bank begins foreclosure. In March, Debtor files a voluntary Chapter 11 Petition.
Debtor’s principal objective, in the bankruptcy, is to ensure that its partners retain title to the property to avoid $20 million in personal tax liabilities from a foreclosure.
Bank is under-collateralized: Debtor’s 15 floors are worth $54.5 million, leaving Bank’s $93 million loan with an unsecured deficiency of $38.5 million.
Debtor proposes a reorganization plan that would:
- pay Bank’s $54.5 million secured claim in full over time;
- discharge Bank’s $38.5 million unsecured deficiency;
- pay in full and in cash the unsecured claims of outside trade creditors totaling $90,000;
- allow Debtor’s former partners to pay $6.125 million for ownership of the reorganized debtor; and
- limit such payment/ownership opportunity to old equity holders.
Bank objects and blocks a consensual confirmation.
So, Debtor pursues a “cramdown” for imposing the plan on Bank’s dissenting class.
—North LaSalle and the Absolute Priority Rule
The Rule. Conditions for a cram down include:
- At least one class of impaired claims must accept the plan (here, the trade creditors class voted to accept); and
- As to a dissenting class, (a) the allowed claims are paid in full, or (b) the ownership class “will not receive or retain under the plan on account of such junior claim or interest any property.”
This latter condition is the core of what is known as the “absolute priority rule.” And this rule is the basis for Bank’s position that the plan could not be confirmed as a cramdown.
Lower courts reject the Bank’s position—all of them: the Bankruptcy Court approves the plan, the District Court affirms, as does the Court of Appeals.
The Supreme Court grants certiorari and reverses, declaring that Debtor’s proposed plan fails to satisfy the absolute priority rule.
History. The term “absolute priority rule” and its “new value corollary” (or “exception”) are creatures of law antedating the Bankruptcy Code.
The old Bankruptcy Act contained no provision like today’s § 1129(b)(2)(B). Instead, the subject is addressed, under the Act, by two interpretive rules: (i) under §77B, and (ii) in Case v. Los Angeles Lumber Products Co.:
- Under § 77B, a plan must be “fair and equitable”—the concern is that plans proposed by debtors are too good a deal for debtor’s owners because of “the ability of a few insiders . . . to use the reorganization process to gain an unfair advantage.” Hence judges respond with the absolute priority rule, requiring that creditors be paid “before the stockholders could retain equity interests for any purpose whatever.”
- In Case v. Los Angeles Lumber Products Co., the U.S. Supreme Court provides these observations, which have never risen above the level of dictum in any subsequent Supreme Court opinion:
“[T]here are circumstances under which stockholders may participate in a plan of reorganization of an insolvent debtor …. Where the necessity for new capital exists and the old stockholders make a fresh contribution and receive in return a participation reasonably equivalent to their contribution, no objection can be made”; and
“[W]here the debtor is insolvent, the stockholder’s participation must be based on a contribution in money or in money’s worth, reasonably equivalent in view of all the circumstances to the participation of the stockholder.”
The U.S. Supreme Court last addressed the absolute priority rule (prior to 203 North LaSalle) in Norwest Bank Worthington v. Ahlers, 485 U. S. 197 (1988), holding that a contribution of labor, experience, and expertise by a junior interest holder was not the money’s worth that the Case v. Los Angeles observations require.
Enactment of the Bankruptcy Code might have added a new value exception or corollary—but Congress chose not to do so.
Such an exception or corollary may exist. But Debtor’s plan is doomed, nonetheless, by vesting new ownership upon the old owners, exclusively. Such a provision is an item of “property” in its own right: its very purpose is to do old equity a favor.
It is the exclusiveness of the opportunity, without competing bids or a competing plan, that renders old owners’ right a “property” interest extended “on account of” the old equity position.
Such a plan provision requires that a bankruptcy judge determine whether the new value is sufficient, while the best way to do so is by market exposure. That’s important because the Code narrows the occasions for courts to make valuation judgments (see, e.g., its supramajoritarian class creditor voting scheme in § 1126(c)).
Supreme Court’s Summary. We do not decide whether a market test requires, (i) an opportunity to offer competing plans, or (ii) a right to bid for the same interest. It is enough to say that plans providing junior interest holders with exclusive opportunities free from competition and without benefit of market valuation fall within the prohibition of § 1129(b)(2)(B)(ii).
Conclusion
For businesses and individuals that can’t qualify for Subchapter V or for Chapter 12, the absolute priority rule is an impediment to successful reorganization in Chapter 11.
Any such business and individual in Chapter 11 will need to develop a strategy for addressing the absolute priority rule.
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Footnote 1. The absolute priority rule is contained in 11 U.S.C. § 1129(b)(2)(B) and reads as follows:
“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.”
Footnote 2. See Louisville Trust Co. v. Lousiville, New Albany, 174 U.S. 674 (1899).
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