In In the Matter of Castleton Plaza, LP,¹  the Court of Appeals for the Seventh Circuit held that a new value plan that leaves creditor claims unpaid must be subjected to a market test if the new value is contributed by an insider. The decision by the Seventh Circuit expanded the competition requirement to insiders whether or not the insider is a holder of a claim or interest against the debtor. The Castleton decision could be read to be a substantial expansion of both the requirements of 1129(b)(2)(B) and the Supreme Court decision in Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Partnership, 526 U.S. 434 (1999).

The Castleton decision involved a restructuring of Castleton Plaza, LP which owned a shopping center in Castleton, Indiana. George Broadbent owned 100 percent of Castleton Plaza, LP, 98 percent of it directly and 2 percent indirectly. Castleton Plaza, LP was obligated to EL-SNPR Note Holdings on a $10 million secured note with a stated interest rate of 8.37 percent per annum. The note included lockboxes and a variety of other covenants. The note matured and Castleton filed for chapter 11. In the chapter 11 plan, Castleton proposed a nonconsensual treatment for EL-SPNR which would have resulted in EL-SPNR receiving $300,000 in cash and a new note with a principal amount of $8.2 million and a stated interest rate of 6.25 percent per annum. The unsecured creditors would have received 15 percent of their claims under the plan. The equity in the reorganized Castleton would have been distributed to George Broadbent’s wife, Mary Broadbent, for a new value investment of $75,000. Mary Broadbent was not a holder of a claim or interest in Castleton but was the owner of The Broadbent Company, Inc. which managed Castleton Plaza. The plan also provided for assumption of the management contract. George Broadbent was the CEO of Castleton and received an annual salary of $500,000 from The Broadbent Company.

EL-SPNR believed that Castleton’s assets were being undervalued and offered a proposal that would have resulted in a 100 percent return to unsecured creditors and a $600,000 payment to equity. Presumably, EL-SPNR would have acquired Castleton Plaza through its plan. Castleton rejected the proposal, but increased Mary Broadbent’s new value infusion to $375,000. EL-SPNR responded by asking the Bankruptcy Court to require a competitive bidding process. The Bankruptcy Court determined that competition was unnecessary because Section 1129(b)(2)(B)(ii) only applies to holder of claims or interests in a junior class receiving a distribution while senior classes go unpaid. Since Mary Broadbent was not a holder of a claim or interest, the Bankruptcy Court determined that 1129(b)(2)(B)(ii) was not implicated and that therefore 203 North LaSalle did not require competition. The Bankruptcy Court confirmed the plan proposed by Castleton.

On direct appeal, the Seventh Circuit determined that the Bankruptcy Court was wrong and that competition was necessary if a plan distributed equity to an insider regardless of whether that insider was a holder of a claim or interest in the debtor. The Seventh Circuit’s decision seems, in part, to have been based on the particular facts of this case which were fairly egregious. As the Court indicated, “a new-value plan bestowing equity on an investor’s spouse can be just as effective at evading the absolute priority rule as a new-value plan bestowing equity on the original investor.”²  The Court went on to discuss the seeming control that George Broadbent had exercised over the entire process as a reason that the process was fundamentally tainted and required competition.

More importantly, though, the Seventh Circuit seemed to focus on the benefits of a competition to the chapter 11 process, particularly where insiders³  are involved. The Seventh Circuit stated that “plans giving insiders preferential access to investment opportunities in the reorganized debtor should be subject to the same opportunity for competition as plans in which existing claim-holders put up the new money.”⁴  The Seventh Circuit seems to view competition as both valuable and cleansing to the process.

The Supreme Court in 203 N. LaSalle emphasized the exclusive nature of the option to be the new investor as a reason why the “new value” plan in that case violated the absolute priority rule. Some courts have focused on that point to hold that no market test is required if the debtor’s exclusive period to file a plan has expired.⁵  The Seventh Circuit flatly rejects that approach, stating “Competition helps prevent the funneling of value from lenders to insiders, no matter who proposes the plan or when. An impaired lender who objects to any plan that leaves insiders holding equity is entitled to the benefit of competition.”⁶

The future impact of the Castleton decision is difficult to determine. It would be easy to dismiss the decision as simply a product of bad facts. The emphasis by the Seventh Circuit on the benefits of competition, however, suggests that at least in the Seventh Circuit the decision may have broader implications. If the Castleton decision is applied to require competition in any situation where insiders receive equity, competition would certainly be required in circumstances where the new-value is provided by an affiliate of existing equity. The competition requirement might also be imposed when management receives equity where they are going to be part of the going-forward management team.⁷  Maybe more importantly, if the Seventh Circuit is making a point about the intrinsic value of competition in the plan context, all new-value plans and maybe even other plans of reorganization could be subjected to competition.

_{1 ___ F.3d ___, 2013 WL 537269 (7th Cir.) (Feb. 14, 2013) (Easterbrook, C.J.).}  

_{2 Id. At *2.} 

_{3 While the “insider” in this case was the debtor’s spouse, the Code’s definition of insider is much broader and would include, inter alia, officers and affiliates of the debtor. See 11 U.S.C. § 101(31).} 

_{4 Castleton, 2013 WL 537269 at *2.}  

_{5 See 7 Collier on Bankruptcy ¶ 1129.03[4][c][iii][E] (16th ed.); citing In re Davis, 262 B.R. 791, 798-99 (Bankr. D. Ariz. 2000) and In re 68 W. 127 St., LLC., 285 B.R. 838, 841 (Bankr. S.D.N.Y. 2002).} 

_{6 Castleton, 2013 WL 537269 at *3 (emphasis in original).}  

_{7 The Court’s absolute priority rule discussion focused on the value received by the former equity owner, George Broadbent, rather than the statutory term “property.” In that context, the Court noted that George Broadbent received value under the plan because his family’s wealth was enhanced and because he continued to receive a salary from the management contract. If that dicta leads to an extension of the Castleton market testing rule to cases where insiders receive indirect value other than equity, the case could have truly far-reaching implications.}