Senior Class Gifting Is Not The End Of The Story: Some Recent Developments Regarding The Absolute Priority Rule And The New Value Exception

Much attention in the commercial bankruptcy world has been devoted recently to judicial pronouncements concerning whether the practice of senior creditor class "gifting" to junior classes under a chapter 11 plan violates the Bankruptcy Code's "absolute priority rule." Comparatively little scrutiny, by contrast, has been directed toward significant developments in ongoing controversies in the courts regarding the absolute priority rule outside the realm of senior class gifting - namely, in connection with the "new value" exception to the rule and whether the rule was written out of the Bankruptcy Code in individual debtor chapter 11 cases by the addition of section 1115 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"). This article examines these concepts as well as some recent court rulings addressing them.

Cram-Down and the "Fair and Equitable" Requirement

If a class of creditors or shareholders votes to reject a chapter 11 plan, it can be confirmed only if the plan satisfies the "cram-down" requirements of section 1129(b) of the Bankruptcy Code. Among these requirements is the mandate that a plan be "fair and equitable" with respect to dissenting classes of creditors and shareholders. Section 1129(b)(2)(B) of the Bankruptcy Code provides that a plan is "fair and equitable" with respect to a dissenting impaired class of unsecured claims if the creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, in cases not involving an individual debtor, if no creditor of lesser priority, or no equity holder, receives or retains any distribution under the plan "on account of" its junior claim or interest. This requirement is sometimes referred to as the "absolute priority rule."

History of the Absolute Priority Rule

The U.S. Supreme Court first formally articulated the absolute priority rule, originally referred to as the "fixed principle," in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), which involved an equity receivership of a railroad. In Boyd, the old stockholders and bondholders agreed to a plan of reorganization in 1896 pursuant to which the company was to be sold to a new company in which the old stockholders had rights. Boyd asserted an unsecured claim against the predecessor company that resulted in a judgment in 1896 and was revived in 1906. However, because the old railroad's assets had been sold to the new company 10 years earlier, there were no longer any assets on which to levy an execution. Boyd accordingly sued to hold the new company responsible for the old company's debt to him. The Supreme Court ruled that the stockholders' receipt of property was invalid:

[I]f purposely or unintentionally a single creditor was not paid, or provided for in the reorganization, he could assert his superior rights against the subordinate interests of the old stockholders in the property transferred to the new company. They were in the position of insolvent debtors who could not reserve an interest as against creditors. . . . Any device, whether by private contract or judicial sale under consent decree, whereby stockholders were preferred before the creditor, was invalid. * * * *

[I]n cases like this, the question must be decided according to a fixed principle, not leaving the rights of the creditors to depend upon the balancing of evidence as to whether, on the day of sale, the property was insufficient to pay prior encumbrances. Thus was established the "fixed principle"- a concept that later came to be known as the "absolute priority rule." According to this precept, stockholders could not receive any distribution in a reorganization case unless creditor claims were first paid in full. The Supreme Court continued to apply this principle in equity receivership cases throughout the early 1900s, emphasizing that it should be strictly applied. In 1934, Congress amended the former Bankruptcy Act to introduce the words "fair and equitable" to bankruptcy nomenclature. Section 77B(f) of the Act provided that a plan of reorganization could be confirmed only if the bankruptcy judge was satisfied that the plan was "fair and equitable and does not discriminate unfairly in favor of any class of creditors or stockholders and is feasible." The provenance of this restriction was none other than the "fixed principle." As later expressed by the Supreme Court in Bank of America Nat...