Confirmation Denied: Chapter 11 Plan Did Not Satisfy New Value Exception To Absolute Priority Rule Without Market Testing

Published date05 April 2022
Subject MatterEmployment and HR, Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy, Discrimination, Disability & Sexual Harassment
Law FirmJones Day
AuthorMr Paul Green and Mark Douglas

When existing interest holders attempt to retain ownership of a chapter 11 debtor after confirmation of a nonconsensual plan of reorganization, the Bankruptcy Code's plan confirmation requirements, including well-established rules regarding the classification and treatment of creditor claims and equity interests, can create formidable impediments to their reorganization strategy. In In re Platinum Corral, LLC, 2022 WL 127431 (Bankr. E.D.N.C. Jan. 13, 2022), the U.S. Bankruptcy Court for the Eastern District of North Carolina applied the Bankruptcy Code's "cram-down" confirmation requirements in denying confirmation of a chapter 11 plan under which one of the debtor's existing equity holders would receive 100% of the new equity in the reorganized company in exchange for cancellation of a prepetition unsecured "loan" and a $100,000 cash infusion.

According to the court, one of the insiders' loan was properly characterized as a capital infusion and the plan violated the "absolute priority rule" because the old owner, whose claims were subordinate to other unsecured claims, would receive value under the plan without paying the more senior dissenting class of unsecured claims in full. The court also found that the owner's promised $100,000 cash infusion did not satisfy the "new value exception" to the absolute priority rule because the value of the new equity to be distributed to him under the plan had not been market tested.

Classification of Claims and Interests Under a Chapter 11 Plan

Section 1122 of the Bankruptcy Code provides that, except with respect to a class of "administrative convenience" claims (i.e., relatively small unsecured claims, such as trade claims below a certain dollar amount), a plan may place a claim or interest in a particular class "only if such claim or interest is substantially similar to the other claims or interests of such class." The Bankruptcy Code, however, does not define "substantially similar." This task was left to the courts, relying upon past practice under the former Bankruptcy Act and lawmakers' statements in connection with the enactment of the Bankruptcy Code indicating that the term should be construed to mean similar in legal character or effect as a claim against the debtor's assets or as an interest in the debtor. See generally Collier on Bankruptcy ("Collier") ' 1122.03[1] (16th ed. 2022). Thus, interests, such as stock, may not be classified together with claims, such as trade or bond debt, because the relationship between the debtor and its creditors, who assume credit risk but not enterprise risk, is fundamentally different from the relationship between the debtor and its stockholders, who do shoulder enterprise risk as investors.

In passing on the propriety of a plan's claims-classification scheme, courts generally examine the nature of the claim (e.g., senior or subordinated, secured or unsecured) and the relationship of the claim to the debtor's property. For example, secured claims must be classified separately from unsecured claims, and priority claims should not be placed in the same class as general unsecured claims. Id.

Although the Bankruptcy Code provides that only substantially similar claims may be classified together, it does not require that all substantially similar claims be placed into a single class. Instead, substantially similar claims may be divided into separate classes if separate classification is reasonable. Id.

A classification scheme designed to fabricate an accepting impaired class under section 1129(a)(10) is sometimes referred to as class "gerrymandering." The practice can involve, among other things: (i) classification of claims whose holders are favorable to a plan in the same class with the claims of creditors who are not, with the expectation that supporting claims will sufficiently outnumber dissenting claims to ensure acceptance of the plan by the class as a whole; or (ii) separately classifying the claims of dissenting creditors from the claims of creditors favorable to the plan to ensure that the dissenting creditors cannot defeat cram-down confirmation

The latter form of gerrymandering has arisen almost exclusively in single-asset real estate cases, where the plan proponent attempts to classify the mortgagee's unsecured deficiency claim separate from the claims of other unsecured creditors. That practice has been invalidated by a majority of the circuit courts of appeals that have faced the issue. See id. at ' 1122.03[5].


The power to treat a debt as if it were actually an equity interest is derived from principles of equity. It emanates from the bankruptcy court's power to ignore the form of a transaction and give effect to its substance. See Pepper v. Litton, 308 U.S. 295, 305 (1939). However, because the Bankruptcy Code does not expressly empower a bankruptcy court to recharacterize debt as equity, some courts disagree as to whether they have the authority to do so and, if so, the source of such authority.

Every circuit court of appeals that has considered the issue has upheld the power of a bankruptcy court to recharacterize a claim as equity, notwithstanding the parties' characterization of a prepetition advance as a "debt." See generally Collier at ' 510.02 (citing cases). Some circuits have held that a bankruptcy court's power to recharacterize derives from the broad equitable powers set forth in section 105(a) of the Bankruptcy Code, which provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]." See In re Dornier Aviation (N. Am.), Inc., 453 F.3d 225 (4th Cir. 2006); In re SubMicron Sys. Corp., 432 F.3d 448 (3d Cir. 2006); In re Hedged-Invs. Assocs., Inc., 380 F.3d 1292 (10th Cir. 2004); In re AutoStyle Plastics, Inc., 269 F.3d 726 (6th Cir. 2001). In Hedged Investments, the Tenth...

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