This is about bad law in the bankruptcy courts, but let us instructively begin with Charlie Brown. Bear with me. Everyone knows the classic Peanuts comic strip, which features the running joke of Lucy and Charlie Brown playing football – Charlie Brown goes to kick the football, only to have Lucy pull it away at the last second, leaving Lucy laughing and Charlie Brown on his back. Every time, Lucy promises Charlie Brown that this time she will let him kick the ball. Charlie Brown, blithely ignoring the obvious, goes to kick the football. Lucy, of course, pulls the ball away again, every time.
So what does Charlie Brown’s cheery optimism in the face of Lucy’s perfidiousness have to do with lenders and Bankruptcy Court? The U.S. Bankruptcy Court in the Southern District of Indiana has been green lighting a debtor’s use of a bit of boldface legerdemain, over and over again, to keep control and ownership of his properties post-default and post-bankruptcy. If this were to become a common outcome for single asset bankruptcy cases, lenders’ reasonable expectations about bankruptcy would be fundamentally frustrated. So why should a lender keep making non-recourse loans and have the ball pulled away?
It began with In re Greenwood Point, LP, 445 B.R. 885 (2011). There, the court confirmed a plan in which the wife of debtor’s sole direct and indirect owner (the “Owner”) purchased the debtor’s assets for $100,000 under a chapter 11 plan. The debtor (a SARE debtor) owned a retail shopping center in Indiana, which was subject to a mortgage and assignment of leases and rents that served as security for a $7,650,000 loan. The loan went into maturity default, and on the day the Superior Court was scheduled to hold a hearing on the secured party’s motion for a receiver to be appointed, the debtor filed a voluntary petition for relief under Chapter 11. The property was managed by an affiliate, (the “Manager”), and after filing for bankruptcy, the Owner sold his equity in the Manager to his wife in exchange for $50,000. The Owner kept his position as president and CEO of the Manager, and continued to receive an annual salary of $500,000 from the Manager. Over the objections of some of the debtor’s creditors, including the lender, the Court approved the Chapter 11 plan wherein the debtor’s assets were purchased by the Owner’s wife (yup, the same wife who purchased the interests in the Manager), in exchange for a cash infusion of $100,000.
In the next, nearly identical case, In re Castleton Plaza, LP, the same Owner owned all of the equity interests in a different SARE debtor that owned a different retail shopping center in Indiana, on which it had taken out a $9,500,000 loan. In a familiar turn of events, the court confirmed a plan of reorganization in which the equity in the debtor was transferred to the Owner’s wife (same wife) and the Manager (which, if you remember, is now owned by his wife and managed by Mr. Owner as president and CEO) in exchange for a $75,000 cash infusion from the missus. This case is currently on appeal before the Seventh Circuit.
But wait, and I’m not making this up, there is a third case, In re Georgetown Plaza LP, working its way through Bankruptcy Court in Indiana, in which the same Owner owns yet another retail shopping center and has proposed yet another cramdown plan of the same type. And if the courts will keep confirming them, why not! This case is currently before the Bankruptcy Court and no plan of reorganization has yet been approved.
The issue in each of these cases is the same. The courts have had to evaluate whether the plan violated the Bankruptcy Code’s Absolute Priority Rule (11 U.S.C. §1129(b)(2)(B)(ii)). The Absolute Priority Rule requires that the claims of an objecting impaired class of creditors must be paid in full before the equity may retain any interest, unless the equity contributes “new value” to the enterprise. New value must be contributed (1) in money or money’s worth, (2) be reasonably equivalent to the value of the new equity interest in the reorganized debtor and (3) be necessary for implementation of a feasible reorganization plan. (See the LaSalle case for an in depth discussion of the Absolute Priority Rule.) Although the court in Castleton Plaza held that the Owner’s wife and Manager were insiders, and any proposed sale to an insider is subject to a higher degree of scrutiny when evaluating the Absolute Priority Rule, the court stopped short of requiring that such a sale to an insider be market tested to establish that the “new value” was adequate. The court determined that because the Owner’s wife was not just a “straw man” for the Owner (she was using her own money to fund the purchases, which would be added to her own substantial investment portfolio), she was not former equity – only an insider of former equity. Other courts (for example, here and here) have required a market test where sales to insiders are concerned. That is just common sense.
In addition to the outcome of the application of the Absolute Priority Rule, the other issues before the Seventh Circuit on appeal are (1) whether the sale of equity interests to an insider violates the Bankruptcy Code (§363(b)) where there has been no market test, (2) whether treatment of the lender’s secured claim was “fair and equitable” (§1129(b)(1)) and (3) whether the plan was “feasible” (§1129(a)(11)). (Similar issues were raised in Greenwood and are being argued in Georgetown Plaza).
In each instance, the lenders’ primary objection is that the amount of money constituting the “new value” was not market tested, and was far below any reasonably equivalent value of the equity stake in question. And in each case, the debtor’s argument was that there was no market for the asset and any market test was impossible. To make it worse, in the Castleton Plaza case, the lender offered to pay double what the Owner’s wife had paid, but the court still confirmed the debtor’s proposed plan.
This just doesn’t seem to pass the giggle test. You should not be able to avoid the clearly intended outcome of a completely underwater single asset real estate bankruptcy, e.g., turnover of the collateral to the lender, by having some blood relative shill for the old equity where the only testimony on the value of the equity interests comes from the debtor and pretend it’s all an arm’s length bona fide reorganization through the infusion of new equity. I mean, I give our debtor points for chutzpah and creativity, but this is wrong and we hope the Seventh Circuit gets it right. The Bankruptcy Code needs to provide consistent and predictable outcomes for situations where the debtor cannot repay the debt. This isn’t that. Bad decisions like these impair credit formation. Add this to other recent regulatory and judicial mischief which frustrates the reasonable expectations of the parties to a lending relationship and the willingness of lenders to lend will be suppressed.
Maybe this gets fixed. If not, it’s yet another “teachable moment” that the judicial process will often disappoint. Decisions like these serve as a reminder of the difficulty lenders can face in bankruptcy, which at times seems less like a sensible and predictable process for resolving insolvency and more like a get-out-of-jail card for the nimble debtor. I guess this is what is meant by a “fresh start”.
By: Linda Ann Bartosch, Krystyna Blakeslee, and Rick Jones.