Amicus Curiae Brief — US Bancorp Mortgage Co. v. Bonner Mall Partnership

Supreme Coud, OX |

| FILED

4

a detal iad FEB 22 1994

sctictaasiie cattatielnce! celal CLERK

In The

Supreme Court of the United States

October Term, 1993

:

|

U.S. BANCORP MORTGAGE COMPANY,

Petitioner,

BONNER MALL PARTNERSHIP,

Respondent.

°

On Writ Of Certiorari To The

United States Court Of Appeals

For The Ninth Circuit

¢

AMICUS CURIAE BRIEF OF CHARLES W. ADAMS

IN SUPPORT OF NEITHER PARTY

+

CHaRLes W. ADAms

Professor of Law

The University of Tulsa College

of Law

3120 East Fourth Place

Tulsa, OK 74104

(918) 631-2437

Amicus Curiae

COCKLE LAW BRIEF PRINTING CO., (800) 225-6964

OR CALL COLLECT (402) 342-2831

TABLE OF CONTENTS

The Purpose of Chapter 11

The Source of the Capital Contribution... .

The Form of the Capital Contribution

The Amount of the Capital Contribution... 11

Application to the Facts of This Case

Conclusion

4,

ii

TABLE OF AUTHORITIES

Cases

Butner v. United States, 440 U.S. 48 (1979)........... 11

Case v. Los Angeles Lumber Co., 308 U.S. 106 (1939). . passim

In re Bonner Mall Partnership, 2 F.3d 899 (9th Cir.

BIDS)... osc ccccccseceeuevdesinenils wan bn itis ennnnne 18

In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977) .... 17

Kham & Nate’s Shoes No. 2, Inc. v. First Bank, 908

F.2G 1351 (7th Cle. 2996)... ccicccsscckenpenes 8, 9, 11

Northern Pacific Railway v. Boyd, 228 U.S. 482

(BDLS) 0. cccccccevcccccegensse che aenmeninennannee 6

Norwest Bank Worthington v. Ahlers, 485 U.S. 197

(BSGG) . . 0. ssc cccceceecccesstepa einen ne naneannnE 7,9

STATUTES AND OTHER AUTHORITIES

11 USC. § 2129. ....cccdvcdesadeunceueee 2, 15

BZ USA. § Fh. ...00.c00cceeeeeens penne 5

idaho Const. ast. XI, @ 9... ccevestas ene 19

Idaho Code §§ 30-1-18, 30-1-21.................e00ee 18

Idaho Code § 30-1-19...<icdeosssus bk, eae 19

Regulation Y, 12 C.RR. § 225.22.......ccccccssccccess 5

1 Model Business Corp. Act Ann. § 6.21 (3d ed.

BGP)... oc cccgeceveccesios.nctns sane 9, 10, 11

1 Model Business Corp. Act Ann. § 19 (2d ed.

BG71)... .occcccccesuneelen anneal 9, 10

79 Fed. Reserve Bull. A37 (Sep. 1993)............... 19

*

iii

TABLE OF AUTHORITIES - Continued

Charles W. Adams, An Economic Justification for

Corporate Reorganizations, 20 Hofstra L. Rev. 117

DP ccseneb dibheteteubenednced¢ecescagesscoce

Frederick K. Beutel & Milton R. Schroeder, Bank

oray Handbook of Commercial Banking Law

4-30, 5-30 (Sth ed. 1962) .........ccccccccess

Douglas G. Baird, [he Initiation Problem in Bank-

ruptcy, 11 Int'l. Rev. L. & Econ. 223 (1991).....

Milton Harris & Artur Raviv, The Theory of Capital

Structure, 46 J. Fin. 297 (1991) .............0...

John B. Levy, Regulations Prompt Higher Minimum

Spreads, 35 Nat'l Real Estate Investor 24 (Mar.

SAGO N eel 66 hehe Eick sdeveddecceeeécctwoces

Lynn M. LoPucki & William C. Whitford, Patterns

in the Bankruptcy Reorganization of “~~ Publicly

Held Companies, 78 Cornell L. Rev.

Bruce A. Markell, Owners, Auctions, and Absolute

Priority in Bankruptcy Reorganizations, 44 Stan. L.

DT tntguts eluk ctcackesduans dh<caens

(1993) ..

Page

a

Letters from the parties consenting to the filing of this

amicus curiae brief have been filed with the Clerk.

¢

INTEREST OF AMICUS CURIAE

1 am not representing a client, and the views

expressed in this brief are my own. I have no monetary

interest in this or any other bankruptcy case. Aside from

wishing to assist the Court, my interests in this case are

entirely academic. I am a Professor of Law at The Univer-

sity of Tulsa College of Law, where I have taught courses

in creditors’ rights and bankruptcy. I am the author of An

Economic Justification for Corporate Reorganizations, 20

Hofstra L. Rev. 117 (1991). I had completed a forthcoming

article dealing with capital contributions in Chapter 11

reorganizations when the Court granted certiorari in this

case.

°

SUMMARY OF ARGUMENT

This brief supports the Respondent's position that

the Court should recognize a new capital exception to the

absolute priority rule. However, it is opposed to the

Respondent's plan of reorganization because the plan

does not appear to provide an adequate equity cushion in

the debtor’s capital structure following reorganization.

_ Consequently, this brief is aligned with neither party.

The purpose of a Chapter 11 reorganization is to

repair an insolvent company’s dysfunctional capital

structure. It should not matter whether the new capital

1

that an insolvent company needs for a successful reorgan-

ization comes from its creditors, outside investors, or its

former owners. What is critical to the reorganization is

the substance (i.e., the form and amount) of the new

capital contribution, rather than its source. In addition to

recognizing the new capital exception, the Court should

clarify the size of the capital contribution that is required.

The prevailing standard from Case v. Los Angeles Lum-

ber Co., 308 U.S. 106, 121-22 (1939), is unworkable. While

superficially plausible, the Los Angeles Lumber standard

turns out on closer analysis to be merely a tautology. It

should be replaced by a standard requiring an investment

of sufficient new capital that the reorganized company

will have a capital structure solid enough to withstand

future adversity without failing again. This standard

derives from the “feasibility requirement” in 11 U.S.C.

§ 1129(a)(11). Section 1129(a)(11) prescribes that a bank-

ruptcy court shall confirm a reorganization plan only if it

“is not likely to be followed by the liquidation, or the

need for further financial reorganization, of the debtor.”

¢

ARGUMENT

I. The Purpose of Chapter 11

A bankruptcy reorganization is a process for restor-

ing financial health to an insolvent business through an

adjustment of its capital structure. Generally, the adjust-

ment involves the discharge of some debt and the infu-

sion of new capital from either outside investors, the

company’s creditors, or its owners.

3

A business normally is financed partly through

equity and partly through debt. Some equity is essential

in a company’s capital structure to capture the residual

interest in its future earnings. Most companies also have

substantial levels of debt financing. Besides offering a tax

benefit, debt in a company’s capital structure provides

leverage to owners, enabling them to earn a higher

expected return, though at greater risk.

Excessive debt, however, produces a risk of default

and a possible conflict of interest between the company’s

owners and its creditors. A conflict of interest may arise

because the owners are entitled to the profits if the busi-

ness succeeds, while the maximum return for the credi-

tors is the stated rate of interest. In a company where

most of the capital structure is debt with its owners

having only a small amount of equity invested, the

owners will have an incentive for excessive risk-taking.

The owners have everything to gain if a risky venture —

succeeds, and nothing but their limited equity to lose if it

fails. The creditors, on the other hand, will continue to

earn only their fixed interest payments if the venture is

successful, while they risk nonpayment of the loan princi-

pal if it fails.

The risk of default and the potential conflict of inter-

est associated with a leveraged capital structure are nor-

mally held in check by the maintenance of a suitable

equity cushion. An equity cushion represents the owners’

stake in the enterprise, and the presence of a substantial

equity cushion insures that most of the risk is borne by

the owners, rather than the creditors.

An insolvent company has a pathological capital

structure. Because liabilities already exceed asset value,

an insolvent company’s owners have nothing more to

lose from further operating losses. Rather than maximiz-

ing the expected return from operations, the owners’

primary concern will be to have the business earn a

sufficient return so that it can become solvent again.

Because owners of an insolvent company bear none of the

downside risk, they will favor risky ventures with the

potential for large gains over others with more predict-

able, but smaller, gains. Until the business achieves sol-

vency, moderate gains will benefit only the creditors and

not the owners.

Unfortunately, both the creditors and owners of an

insolvent business lack incentives for maximizing its long

term interests. Insolvency generates destructive conflicts

of interests between the company’s owners and creditors,

with the owners seeking to have the business take exces-

sive risks and the creditors trying to collect as much on

their claims as they can through seizure of the company’s

assets. A company cannot operate effectively until these

conflicts are resolved. It is the resolution of these conflicts

through the restoration of a sound capital structure that is

the fundamental purpose of the bankruptcy reorganiza-

tion process. Charles W. Adams, An Economic Justification

for Corporate Reorganizations, 20 Hofstra L. Rev. 117,

117-38, 157-58 (1991).

Il. The Source of the Capital Contribution

There are only three potential sources of capital for

an equity cushion in a reorganized company: the com-

pany’s creditors, outside investors, and its existing

owners.

First, the company’s creditors may provide the neces-

sary capital through a conversion of some of their debt

into equity. A satisfactory capital structure can be

restored by discharging part of the debt (the portion

above the company’s going concern value) converting

some debt to equity to create an equity cushion, and

allowing the remainder to continue as debt in the reor-

ganized company. A major disadvantage of this approach

to reorganization is that it may not be feasible for some

creditors to become equity owners of the reorganized

business. Banks, for example, are a major source of debt

financing, and the Glass-Steagall Act, 12 U.S.C. § 24 (Sev-

enth), imposes significant restrictions on their ownership

of common stock. See Regulation Y, 12 C.F.R.

§ 225.22(c)(1)(i) (bank holding companies may hold vot-

ing securities that are acquired in the ordinary course of

collecting a debt if they are divested within two years of

acquisition); Frederick K. Beutel & Milton R. Schroeder,

Bank Officer's Handbook of Commercial Banking Law §§ 4-30,

5-30 (5th ed. 1982).

Outside investors are an alternative source of new

capital for the equity cushion. Again, the portion of the

debt above the company’s going concern value will have

to be discharged with the remainder continuing as debt in

the reorganized company. In return for their new capital

contributions, the outside investors receive ownership of

the reorganized company, and their ownership interests

constitute the equity cushion. A major disadvantage to

this approach is that it may be difficult to find outside

investors willing to contribute capital to an insolvent

company.

‘ee

INTEREST OF THE AMICI CURIAE

The California Bankers Association (“CBA”) and the Ameri-

can Bankers Association (“ABA”) jointly file this brief as amici

curiae in support of Petitioner U.S. Bancorp Mortgage Company.*

Amici are associations that represent banks in California and

across the country. The CBA is the principal trade association for

the lending industry in California. It represents virtually all of the

commercial banks and trust companies in California. The ABA is

the principal trade association for the commercial banking indus-

try in the United States. It represents commercial banks of all

types and sizes in each of the fifty states and the District of

Columbia. Together, ABA member banks represent approxi-

mately ninety percent of the assets of the nation’s banks.

This appeal is of vital interest to the CBA, the ABA and their

member banks. This Court’s decision will have wide-ranging legal

and practical consequences for virtua’?» every lender in the

United States. The determination whether the owners of busi-

nesses in chapter 11 may retain their equity interests by contribut-

ing “new value,” but without paying objecting creditors in full,

will affect not only lenders’ litigation and negotiation strategies in

bankruptcy cases but their actions in making new loans and

working out troubled loans as well.

This brief is filed pursuant to Rule 37.3 of the Rules of this

Court. The parties have consented to the filing of this brief. Their

letters of consent have been filed with the Clerk of this Court.

* See Addendum 1

SUMMARY OF ARGUMENT

The new value rule’ has never been more than a theoretical

construct. The rule originated in a Supreme Court dictum that

pre-dated the current bankruptcy code’ by almost fifty years and

‘ Although there is some controversy over the proper terminology,

amici will simply refer to the concept as the “new value rule.”

711 U.S.C. §§ 101 et seq., as amended (hereinafter “Code”). All

“Section” references herein are to the Code unless specified otherwise.

2

was virtually unused under pre-Code law.’ To the extent that

there was a new value rule under the Act, its purpose was to

protect majority creditors from the harsh results that sometimes

attended the absolute priority rule, namely allowing even a single

creditor to block confirmation of a plan accepted by the majority.

With the enactment of the Code, any new value rule that even

theoretically existed under the Act was abolished.* The Code has

complex rules for allocating reorganization value, requiring that

each class of unsecured creditors receive “fair and equitable”

treatment in accordance with the absolute priority rule (unquali-

fied by any new value rule); alternatively, a class can consent to

alternative treatment by specific majority vote, and thereby bind

dissenters. The Code thus eliminates the intra-creditor conflict

that gave rise to the new value rule. Under the Act, the new value

rule was used as a weapon by majority creditors against dissent-

ers; under the Code, its only use is by owners against majority

creditors.

The new value rule upsets the Code’s careful balance among

secured creditors, senior and junior unsecured creditors and

owners, which is apparent throughout chapter 11. The new value

rule also undermines an important philosophic premise of the

Code, which is to substitute negotiation and class voting for

judicial resolution of competing interests. The Code does not give

courts the power to change the rules on general equitable grounds.

As a matter of policy, the new value rule is highly costly and

disruptive. Since virtually all debtors are insolvent, the costs of

bankruptcy fall almost entirely on creditors. The rule delays

resolution of bankruptcy cases (by giving owners an incentive for

strategic delay), gives additional leverage to owners, increases

transaction costs (by substituting a vague standard for the specific

> Act of July 1, 1898, ch. 541, 30 Stat. 544 (1898), as amended

(repealed October |, 1979) (hereinafter “Act’”).

* Because the parties have briefed the relevant issues of statutory

interpretation at length, amici will focus primarily upon the historical

and policy basis for a clear absolute priority rule as codified in 11 U.S.C.

§ 1129(b).

3

legal tule of Section 1129(b)), and leads to transfers of reorgani-

zation value from creditors, where Congress has said it belongs, to

existing owners. In short, the new value rule distorts priorities set

we prolongs cases, and inevitably increases the cost of

c t.

ARGUMENT

I. The Primary Pre-Code Use Of The New Value Rule Was

To Deal With Dissenting Minority Creditors.

There is no new value rule in the Code, and it is not seriously

argued that the rule should be recognized on its own merits.

Instead, proponents argue that it was a settled doctrine under pre-

Code law that should be read into the Code. In this Part, amici

show that the historical underpinnings of the rule are dubious at

best, and that the rule was not such a well-established feature of

pre-Code law that it should be deemed incorporated into a new

and radically different statutory scheme.

A. Development Of The Absolute Priority Rule.

In the late nineteenth and early twentieth centuries, spurred by

the widespread failure of America’s railroads, the focus of bank-

ruptcy law began to change from liquidation to reorganization.

What is now universally referred to as the “absolute priority rule”

— ie. that a debtor's creditors must be paid in full before its

owners may retain value — developed in the context of the first

railroad reorganizations, which were accomplished through equity

receiverships.

These early reorganizations often centered around “friendly

foreclosure” arrangements between secured creditors and owners

which had the effect of transferring the debtor’s assets to a new

entity (encumbered by all or some of the old secured debt),

leaving unsecured creditors with nothing more than a shell from

which to seek collection of the amounts owed them, and enabling

owners to retain the assets and going concern value of the

4

reorganized enterprise.° The absolute priority rule developed in

response to unsecured creditors’ complaints that these early

aiTangements improperly eliminated their rights.°

The first step in the formulation of the absolute priority rule

was to permit unsecured creditors to challenge these receivership

transactions based on the distinction between a typical mortga-

gor/mortgagee foreclosure (which eliminates all inferior claims)

and these “friendly” foreclosures (which eliminated junior credi-

tors’ rights but allowed owners to retain an interest after the

foreclosure).’ Then, courts turned to consider the exact scope of

those rights. In the landmark case of Northern Pac. Ry. v. Boyd,

228 U.S. 482 (1913), this Court struck a balance among the

desirability of continuing to operate a railroad, the need for funds

to do so (recognizing owners as the most likely source of those

funds), and the unsecured creditors’ rights by articulating a

standard which required a “fair offer” to unsecured creditors.

After Boyd, two competing definitions of “fair offer” were

suggested: a rule of “absolute priority” which recognized state law

claims and did not permit owners to participate in the reorganized

debtor unless those claims were satisfied in full, and a rule of

“relative priority” which permitted owners to participate if earn-

ings met certain levels and relative priorities among classes were

observed.* In 1933 and 1934 Congress entered the fray by adding

Sections 77 and 77B to the Act. While Sections 77 and 77B were

* See Markell, Owners, Auctions and Absolute Priority in Bankruptcy

Reorganizations, 44 Stan. L. Rev. 69, 78-80 (1991) (hereinafter “Mar-

kell”); Ayer, Rethinking Absolute Priority After Ahlers, 87 Mich. L.

Rev. 963 (1989) (hereinafter “Ayer’”).

* See, e.g., Louisville Trust Co. v. Louisville, New Albany & Chicago

Ry., 174 U.S. 674, 689 (1899).

” See, e.g., Louisville Trust Co., 174 U.S. at 683-84; Chicago, RI. &

P.R.R. v. Howard, 7 Wall. (74 U.S.) 392 (1868).

* See Markell at 82. See also 6A Collier on Bankruptcy, { 11.06 (14th

ed. 1978).

=" Swe’ ee ee

5

not identical,’ they both required that plans be fair and equitable

as to each creditor and that all classes of affected creditors accept

the plan by the required class vote.

The conflict between the relative priority and the absolute

priority “camps” finally reached this Court in Case v. Los Angeles

Lumber Prods. Co., 308 U.S. 106 (1939). In Case, this Court

considered whether “fair and equitable” as used in Section 77B of

the Act embodied the concept of relative or absolute priority. This

Court ruled that both majority creditor consent and a determina-

tion that the plan was fair and equitable were required for

confirmation. It then held that the statute’s use of the term “fair

and equitable” incorporated the absolute priority approach, and

thereby effectively ended the absolute priority versus relative

priority debate.

B. Dissenters’ Power And The Use Of The New Value Rule.

Sections 77 and 77B of the Act provided unsecured creditors

with the right to vote by class on reorganization plans and

required that a reorganization plan be fair and equitable as to each

creditor, thus permitting an outvoted class member to block

confirmation of a plan by convincing the court that the plan was

not fair and equitable. But because absolute priority had prevailed

in Case, the new rule lacked the flexibility that had been present

in equity receiverships. Given the need for capital, the available

sources of such capital, and the leverage of dissenting creditors,

and faced with a strict absolute priority requirement, the courts

struggled to fashion a rule that would ize “certain practical

considerations,”'° Case, 308 U.S. at 117, and allow confirmation

* Section 77, providing for railroad reorganizations, was enacted in

1933 (Act of March 3, 1933, Ch. 204, § 77, 47 Stat. 1467, 1474

(1933)); Section 77B applied to other kinds of corporations and was

a 1934 (Act of June 7, 1934, Ch. 424,§ 77B, 48 Stat. 911, 912

)).

” The problem was particularly acute for railroads, where significant

public interests were at stake. See, e.g, Louisville Trust Co..174 US. at

682; Ecker v. Western Pac. R.R., 318 U.S. 448 (1943).

6

of plans without “requir[ing] the impossible.” Boyd, 228 U.S. at

508. Perhaps recognizing the dilemma, in Case, this Court stated

in dicta that owners could under some circumstances participate

in a plan, but only “based on a contribution in money or money's

worth, reasonably equivalent in view of all circumstances to the

participation of the stockholder,” and only if “it satisfactorily

appears that full recognition has been given to the value of

creditors’ claims,” 308 U.S. at 121, 122 — a test that was not met

by the Case owners, whose proposed contributions were

intangible.

Thus, this Court's first statement of the new value rule was in

dicta, gave no guidance as to the actual conditions under which it

might be applied, and did not discuss how the new value rule

could coexist with the absolute priority rule. No subsequent pre-

Code decisions of this Court upheld as fair and equitable a plan

providing for owner participation where senior claims were not

satisfied in full.'' In fact, there appear to be no published

decisions under the Act adopting the rationale set forth in the

Case dictum to confirm a new value plan over the objection of a

dissenting creditor.’

It is critical to note, however, that whatever new value rule may

have existed after enactment of Sections 77 and 77B of the Act

could never be used to confirm a plan over the objection of an

entire class of creditors, since it was a concurrent requirement

that all classes accept the plan by a two-thirds majority. Act

§§ 77B(e¢) (i), 77B(f). Thus, the only purpose of a new value rule

under the Act after enactment of Sections 77 and 77B of the Act

was to permit, in certain obviously extraordinary, but undefined,

'' See Consolidated Rock Prods. Co. v. DuBois, 312 U.S. 510 (1941);

Marine Harbor Properties, Inc. v. Manufacturer's Trust Co., 317 U.S. 78

(1942); Group of Institutional Investors v. Chicago, Milwaukee, St. Paul

& Pacific R.R., 318 U.S. 523 (1943). The more often litigated issue was

the choice between chapter X and chapter XI (which did not contain a

rigorous absolute priority rule). See, e.g. General Stores Corp. v.

Shiensky, 350 U.S. 462, 465-66 (1956).

'? See Ayer at 1016. See also Klee, Cram Down II, 64 Am. Bankr. L.J.

229, 241 (1990).

Il. The New Value Rule Is Inconsistent With

Scheme Of The Code.

Given the weak historical antecedents of the new value rule,

the Court of Appeals’ conclusion that it was an established pre-

Code bankruptcy practice, which Congress did not indicate an

intention to change, seems strained. Any lingering doubt is

resolved by examining the provisions and structure of the Code

itself, which clearly preclude recognition of a new value rule.

A. The Code Eliminates The “Holdout” Problem.

The Code’s provisions for class voting and the applica tion of

the fair and equitable standard literally reversed the statutory

scheme of the Act. Under the Act, any class vote rejecting the

plan was outcome-determinative, while an affirmative class vote

triggered application of the fair and equitable rule as to each

creditor in the class. , under the Code, a class vote

accepting the plan is outcome-determinative, and a class rejection

triggers application of the fair and equitable requiremen t to the

class as a whole.

The new value rule as applied under the Act was, in essence, a

, jon for the majority against the minority, only

invoked to override dissenters from an affirmative majority ity vote.

Because of the

absolu i

no need for a new value rule and without reference to the fair and

equitable standard. Thus, the Code eliminates the possibility that

dissenters will have the power to stymie confirmation — which is

exactly the problem solved by the new value rule. The comple-

mentary goals of giving effect to the wishes of the majority of

creditors, and of having a mechanism to override dissenters, are

met by the workings of the Code itself, and the new value rule is

superfluous.

B. The New Value Rule Is Contrary To The Policies

Underlying The Code.

The new value rule is not, however, merely a harmless holdover

from pre-Code days. Importing the Act’s new value rule into the

radically different statutory scheme of the Code vitiates the

underlying policies of the Code, creates results that are different

from, and sometimes diametrically opposed to, the results ob-

tained by using the new value rule under the Act, and skews the

debtor-creditor balance struck by the provisions of the Code.

The provisions of chapter 11 of the Code represent Congress’

choice of creditor decisionmaking over judicial supervision. At the

time the Code was being crafted, the judicial supervision model

was articulated in the proposal that courts be permitted to

override creditors’ objections to plans which were found to be fair

and equitable, without more precise standards, Markell at 89, and

in the Bankruptcy Commission’s proposal to permit owners to

retain value under conditions to be applied by the court.'* The

judicial supervision model can also be found in both chapters 12

and 13 of the Code, which dispense with any requirement that

creditors approve plans under those chapters.

The Code minimizes the discretionary aspect of plan confirma-

tion under chapter 11. Majority approval of a plan by a class is

both necessary and sufficient for confirmation as to that class,

without either the need for court involvement or the possibility

that the court will override the majority’s choice. Making creditor

‘* Bankruptcy Comm'n of the United States, | Report of the Comm'n

on the Bankruptcy Laws of the United States, H. R. Doc. 137, 93d

Cong., Ist Sess. 256 (1973) (hereinafter “Commission Report”).

Sener

-_—

ee ee

9

choice outcome-determinative in many situations, which in turn

allows creditors to waive the benefits of the absolute priority rule,

was one of the innovations of the Code,'* and is entirely consistent

with the goals served by the new value rule.

In the limited situations under the Code where the bankruptcy

court may review creditors’ choices with respect to plans of

reorganization, as when the majority of creditors in a class rejects

a plan and the plan proponents request confirmation notwith-

standing such rejection, the statute sets forth clearly-stated and

easily-applied rules for the court to follow. Thus, pursuant to

Section 1129(b) (2) (B) (ii), there are two choices: full payment

or no value to junior classes. The facts necessary for the court to

make the required analysis are easily available and readily inter-

preted; moreover, it is easy to understand Congress’ motivation in

permitting the court to override the creditors’ rejection of the plan

if either of these requirements is met. Where full payment is

offered, a rejecting vote is likely to be motivated by something

all available value and their state law rights and priorities are

being preserved.

Allowing use of the new value rule to override the majority

creditors’ rejection of a plan is another matter entirely. First, the

blance ‘to the bright-line standards set forth in Section

1129(b) (2) (B) (ii). In effect, recognizing a new value rule under

the Code strips creditors of the ability to choose their treatment

and allows the judge to sell the equity of the reorganized enter-

prise to the existing owners, at a price determined by the owners

— 4 situation reminiscent of the equity receivership transactions

'S See Klee, All You Ever Wanted to Know About Cram Down Under

the New Bankruptcy Code, $3 Am. Bankr. L.J. 133, 143 (1979).

10

affording creditors the right to credit bid at the sale. See, e.g., 11

U.S.C. §§ 363(k), 1111(b) (1) (B) (ii).

This Court has already made clear that the creditors’, not the

bankruptcy courts’, choice governs. In Norwest Bank Worthing-

ton v. Ahlers, 485 U.S. 197, 207 (1988), where farm debtors

argued that creditors would be better off with a plan permitting

the debtors to retain their interests in exchange for future work,

this Court stated that:

The Court of Appeals may well have believed that peti-

tioners or other unsecured creditors would be better off if

[the debtors’] plan was confirmed. But that determination is

for the creditors to make in the manner specified by the

Code. 11 U.S.C. § 1126(c). Here, the principal creditors

entitled to vote in the class of unsecured credi-

tors... objected to the proposed reorganization. This was

their prerogative under the Code, and courts applying the

Code must effectuate their decision.

Most importantly, however, use of the new value rule under the

Code stands the original purpose of the rule on its head. Under

the Act, since there was no power to override the vote of a

dissenting class, the rule could only be used as a weapon by

majority creditors against the minority; it was a creditor’s right.

Under the Code, the only possible use for the rule is as a weapon

by owners against dissenting classes of creditors. Neither this

Court nor any other court has recognized, approved of, or even

adverted to, the use of the rule for such a purpose.

C. Application Of The New Value Rule Disrupts The Code’s

Careful Balancing Of Interests.

Chapter 11 of the Code represents a complex compromise

among competing concerns: the rehabilitation of debtors, the

rights of secured creditors, and the rights inter se of senior and

junior creditors and owners. This compromise was designed to

balance different parties’ relative strengths in negotiating the plan

and to identify parameters for that negotiation. Recognition of the

new value rule undermines both the compromise and the

legislation.

oe

An A Aree

First, the separate provisions of chapters X and XI of the Act

were combined to create chapter 11 of the Code, with a single

standard for confirming plans.'* The absolute priority rule, which

existed under chapter X but not chapter XI,'” is incorporated into

the new standard, but can be modified by class vote. Owners

cannot preserve their interests without paying creditors in full,

which they could do under chapter XI; however, they can pre-

serve their interests, regardless of whether creditors are fully paid,

if a majority of creditors within each class approves. As a result,

when plans are negotiated owners have to convince creditors that

their proposed contribution justifies whatever interest they seek to

retain. Recognition of the new value rule under the Code negates

this result, because it gives owners a second audience; they can

appeal to the court if they fail to convince creditors.

Second, chapter 11 allows debtors to remain in possession,

which reconciles former chapter X and the Bankruptcy Commis-

sion’s recommendation,'* both of which provided for the appoint-

ment of trustees in every case, with former chapter XI, which left

the debtor in possession. Under the Act, where an independent

trustee was appointed in every significant chapter X case, recogni-

tion of a new value rule did not raise the issues of conflicts of

interest, breach of duty and collusion. Under the Code, though,

recognition of the rule does raise these issues, and vitiates the

compromise.

_ Third, undér chapter 11 debtors are afforded a limited period of

time, which may be extended, in which they have the exclusive

right to propose and confirm a plan of reorganization. This

provision was enacted not in an effort to give the debtor a special

ability to impose a new value plan over the objection of a

* H.R. Rep. 595, 95th Cong., Ist Sess. 220-241 (1977) (hereinafter

“House Report”).

"The “fair and equitable” language was repealed in 1952 because

chapter XI “compositions” contemplated continued equity participation

'* Commission Report at 240.

12

dissenting class of creditors, but in the hope that the debtor’s draft

plan would be a focal point for negotiations. House Report at 231-

232. A new value rule is inconsistent with the Code’s exclusivity

Fourth, Section 1129 carefully balances the rights of dissenters

by permitting a class vote to override minority creditors, but

specifying the treatment of dissenting classes. There is no new

value rule or other equitable principle available to junior creditors

vis-a-vis dissenting senior creditors. It seems anomalous, there-

fore, to give owners a unique, de facto, cramdown power over

classes senior to them through application of the new vaize rule.

Fifth, recognition of the new value rule underminés rights

which Congress gave real property lenders pursuant to Section

1111(b), which was a response to the bankruptcy court’s decision

in Great W. Life Ins. Co. v. Pine Gate Assocs., Lid., 2 B.C.D. 1478

(Bankr. N.D. Ga. 1977). Pine Gate permitted confirmation of a

plan which paid a real estate lender the appraised value of its

collateral and preserved the existing owners’ interests. Congress

enacted Section 1111(b) to ensure that undersecured real estate

lenders, whether or not they would have a deficiency claim under

state law, have a deficiency claim in chapter 11 which can be

voted against a new value plan. See In re Tampa Bay Assoc., Lid.,

864 F.2d 47 (CAS 1989). Recognition of a new value rule under

the Code undermines this protection, and revives the result

Congress sought%o eradicate, by permitting confirmation of Pine

Gate-type plans which reduce the secured creditor’s claim to the

appraised value of the property, make minimal distributions to

unsecured creditors, and allow owners to retain their interests.

The new value rule distorts the dynamics of the central com-

promise that shaped chapter 11 of the Code. The rule negates

unsecured creditors’ principal protection under the Code: the

assurance that if they are not to be paid in full, they will at least

receive all the reorganization value there is to be had.

———— +

00

13

Ill. The Court Of Appeals’ Policy Rationale Is Inconsistent

With The Code, And The “Standards” For The New Value

Rule Are Difficult To Apply.

The Court of Appeals failed to articulate exactly why there

should be a new value rule and how the purported standards for

its use should be applied. Neither failure is surprising: no

discernible bankruptcy policy is served by a new value rule, and it

is difficult to apply vague standards in a vacuum.

A. The Court Of Appeals’ Policy Rationale Is Inconsistent

With The Code.

As discussed above, the new value rule was originally justified

by the need to preserve going concern value, the rigor of the

absolute Priority rule and the disproportionate power of minority

dissenting creditors to disrupt the process. Perhaps recognizing

Apseals caicnale is inapplicable under the Code, the Court of

Appeals sugges t courte’ idi

should be the rehabilitation Pye businesses Spey

concerns; the court cited the difference between going concern

courts to fulfill their

assigned role of balancing the interests of debtors, creditors, old

owners, and the public, guided by the overriding goal of ensuring

the success of the reorganization.” 2 F.3d at 917.

Closer examination proves that the Ninth Circuit's policy

rationale is ephemeral. First, it is difficult to relate to the typical

post-Code cases implicating the rule — which involve single-asset

real estate partnerships, farms and small corporations. Concerns

about minimizing disruption of the economy do not apply in these

Car cane en, 2 lualikely i real estate, and at least some

arm, cases. Moreover, in cases involving businesses enough

tut the eatienti % aggip, On temp attee d On ae ee

virtually precludes its use. For debtors whose ownership is widely

14

or publicly held, participation by all owners is impracticable, and

any plan which attempts to limit participation to some but not all

owners raises issues of securities law requirements and fiduciary

obligations. Lebold v. Inland Steel Co., 125 F.2d 369 (CA7

1941), cert. denied, 316 U.S. 675 (1942); 12B Fletcher Cyc. Corp.

§ 5811 (Perm. Ed.).

More significantly, the Court of Appeals’ rationale is one that

Congress did not adopt. While there certainly are Congressional

statements, and language in decisions of this Court, that describe

a policy in favor of reorganization, those statements merely

describe the provisions of chapter 11 of the Code.'? They do not

form the basis for some additional judicial power to confirm plans

on policy grounds. Professors Blum and Kaplan cautioned against

such an open-ended power as follows:

The trouble with conferring this wide discretion on the

reorganization judge is patent. A chief concern behind the

adoption of the absolute priority doctrine was to prevent junior

investors from gaining participation in a reorganized entity by

trading on the nuisance value of otherwise worthless claims.

Explicit authorization of judicial discretion would again legiti-

mate and encourage that technique. A mass of experience

reveals that courts have generally been prone to accept com-

promises in order to expedite termination of lengthy proceed-

ings over complicated corporate financial matters and to avoid

having to make and carry out hard decisions. Nothing suggests

that this temptation will be less in the future.”

Notwithstanding that Congress was clearly aware that it had

the option of articulating a policy favoring reorganization,”' no

'9 See, e.g., NLRB v. Bildisco & Bildisco, 465 U.S. 513, 527 (1984).

Blum & Kaplan, The Absolute Priority Doctrine in Corporate

Reorganizations, 41 U. Chi. L. Rev. 651, 664 (1974) (hereinafter

“Blum & Kaplan”).

21 In fact, Congress rejected a proposed amendment by the Bank-

ruptcy Commission to liberalize the absolute priority rule to include

continued management or other participation beyond money or money's

worth. Ahlers, 485 U.S. at 205. At no time during the process of

-+-—

15

such policy is reflected in the statute itself, which contains a

number of alternatives to reorganization. Thus, Sections

1123(a)(5)(D) and 1141(d) (3) clearly contemplate plans which

provide for the sale of all of the debtor’s assets; Section

1112(b)(2) authorizes dismissal or conversion of the case if a

plan cannot be effectuated; Section 1121(d) permits termination

of exclusivity; and Section 1104 gives the court the power to

appoint a trustee on discretionary grounds, which could include a

debtor’s inability to confirm a plan. Several of these provisions

offer remedies for the parties’ failure to agree; the one remedy

conspicuously absent is the bankruptcy court’s ability to override

class votes on equitable or policy grounds.

Nor did Congress leave a vacuum on this point to be filled by

the bankruptcy courts. As argued in Part II above, Congress left

the choice between reorganization and liquidation of a chapter 11

debtor to its creditors, even though it certainly knew how to give

the bankruptcy court power to override creditor dissent. Congress

specifically did so in chapters 12 and 13 of the Code by making

creditor consent irrelevant to the confirmability of plans; it did so

in establishing the “adequate protection” concept for the use of

cash collateral and allowing the bankruptcy court, not the affected

creditor, to decide if adequate protection was being provided; and

it did so in permitting plans to be confirmed over a secured

creditor's rejecting vote based on a showing that the plan would

provide the objecting creditor with the value of its interest in the

debtor’s property or the “indubitable equivalent” thereof. See 11

U.S.C. §§ 361, 363, 1129(b) (2) (A) (iii). Section 1129(b) sets

forth different standards for confirming a plan over creditor

rejection with respect to secured and unsecured claims, giving the

bankruptcy court greater discretion as to secured claims.

While arguments can be offered for giving the court broad

equitable powers to confirm plans over creditor opposition and to

balance the interests of debtors, creditors, old owners, and the

enacting the Code did Congress articulate any preference for reorganiza-

tion as a principle of substantive law which should be enforced by the

bankruptcy courts.

16

public,” this view of bankruptcy law simply is not part of the

Code. This Court should not, by decision, insert it at this time.

B. The Courts’ Difficulty In Applying The New Value Rule

Demonstrates Its Infirmities.

In light of the absence of any bankruptcy rationale for the new

value rule, courts have found it virtually impossible to apply and

have failed to articulate consistent standards for its application.

The Court of Appeals summarized the existing standards as

follows: existing owners were required to “offer value that was | )

new, 2) substantial, 3) money or money’s worth, 4) necessary for

a successful reorganization and 5) reasonably equivalent to the

value or interest received.” 2 F.3d at 908.

Experience in applying these standards exposes numerous

structural flaws in the new value rule. Courts applying the

“substantiality” requirement have struggled with the question of

how much is enough. Some courts have suggested that “substan-

tiality” is not a separate requirement at all, whereas others posit

that there must be some proportionality between the new value

and the amount of unsecured debt to be discharged.” Likewise,

courts have struggled with various innovative forms of “money's

worth” such as guaranties, payment of expenses, forgiveness of

existing debt and contributions of property to be used in the

reorganized business.”

The “necessary” component has caused even more interpretive

problems. Some courts do not apply this requirement at all.”

Others, such as the Court of Appeals here, have adopted a

tautological approach — i.e., if the new value is contributed and

22 Compare In re Yasparro, 100 B.R. 91, 97 (Bankr. M.D. Fla. 1989),

with In re Snyder, 967 F.2d 1126 (CA7 1992).

23 Compare In re Potter Material Serv., Inc. 781 F.2d 99, 103 (CA7

1986) (renewal of shareholders’ guaranty held to be new value, even

though existing guaranty arguably unaffected by bankruptcy), with

Kham & Nate's Shoes No. 2, Inc. v. First Bank, 908 F.2d 1351, 1362

(CA7 1990) (shareholders’ guaranty did not constitute new value). See

also Ahlers, 485 U.S. at 203 (labor and expertise not new value).

* See, e.g., In re Henke, 90 B.R. 451 (Bankr. D. Mont. 1988).

—_- -<.--eoOr--

ho ete mk

a ca

17

the negative vote of a dissenting class can be ignored as a result

thus allowing confirmation, the new value is necessary. Still other

courts reason that new capital is needed for the continued

operation of the business and imply that having cash is always

helpful.”* Some courts state that new funds are necessary to pay

current obligations under the plan, and others say that if such

funds are so used they are not necessary.” Finally, some courts

ey | — that no sensible outsider would invest the neces-

Many owners suggest that their contributions are “necessary”

to cash out unsecured claims (usually at a few cents on the

dollar). This creates a structural problem: the Code does not give

owners the power to cash out unsecured claims over their holders’

objection and retain the upside. If creditors do not accept a

proffered cashout, Section 1129(b) makes them owners. Section

363(k) permits secured creditors to “credit bid,” and courts have

interpreted this requirement to be applicable to sales under a

plan. By the same reasoning, unsecured creditors can accept or

reject an offer of partial payment. Permitting owners to force

creditors to accept a lesser cash return undercuts the essence of

* In re Mortgage Inv. Co. of El Paso, 111 B.R. 604, 620 (Bankr. W_D.

Tex. 1990) (must be a showing that capital infusion is necessary for the

continued operation of the debtor).

”* Compare In re Montgomery Court Apartments

(Bankr. S.D. Ohio 1992) (contribution panne to oad oe

and pay obligations under the plan), with In re Sovereign Group, 1985-

27, Lid., 142 B.R. 702, 708 (E.D. Pa. 1992) (infusion of new capital to

pay creditors not necessary to continued operations of debtor).

” In re Aztec Co., 107 B.R. 585, 588 (Bankr. M.D. Tenn. 1989).

* See In re California Hancock, Inc., 88 B.R. 226 (Bankr. CA9

1988). Some have proposed, to solve problems with the new value rule,

that unsecured creditors be permitted to credit bid in the new value

context. See, e.g. Markell at 121-23. However, there are practical

problems in trying to conduct an auction when one bidder is a class

consisting of many creditors. Such procedure is also likely to be

inefficient, costly and time-consuming.

18

the rule set forth in Section 1129(b), which requires full payment

or affirmative class vote. There is no “third choice.”

The meaning of the requirement regarding the value of the

interest to be retained by existing owners is also uncertain. Some

courts require detailed analysis of cash flow and revenues, the

value of control, and the value of tax benefits, while other courts

permit the test to be satisfied by showing the debtor's history of

losses and poor prospects. See In re U.S. Truck Co., 800 F.2d 581,

588 (CA6 1986).

As the courts struggling to apply the new value rule have found,

these purported underlying requirements are inherently uncertain,

and are only made more so when there is no Congressional policy

to serve as a lodestar for the bankruptcy court’s analysis.

IV. The New Value Rule Delays Resolution, Distorts Priori-

ties, Increases the Costs of Reorganization, And Makes

Credit More Expensive And More Scarce.

Policy concerns militate against recognition of a new value rule:

the rule muddies a clear distribution scheme, increases lenders’

costs, and taints the lending process.

A. The Code Adopts Specific Distribution Rules Which

Allocate Ownership Of Insolvent Entities To Their

Creditors.

A reorganization case usually arises from a business, not a

legal, problem. The basic issue in a reorganization case is how to

allocate “reorganization value” among creditors whose claims

have been reduced, restructured or eliminated in accordance with

the distribution rules set forth in the Code. Both the process

selected for allocating reorganization value and the nature of the

rules to be applied within that process are important to creditors

because they affect the timing and amount of creditors’ recov-

eries. This is particularly true in the bankruptcy arena, as most

- rer oY"

.

yp delet 02 Ae Oui e a > v IE. © -

neta car ws set is EN im Se) RAD as i 09

19

debtors are insolvent,” which means that the costs of b

. ankrupt

are largely borne by creditors. a

The Code adopts a litigation mode, which i j

for allocating value.” pea and 0 oh i a.

be applied by the courts overseeing the litigation bear on the

length of time it will take to resolve issues,”? the cost of resolution

and the pressure to compromise. Generally, therefore, creditors’

economic interests are served by precise rules that are uniformly

applied. Such definitive rules “set guidelines for Carrying on

negotiations, largely by validating or invalidating certain lines of

argument and by fixing bou marks upon the areas within

which negotiation is allowable.”’? When entering into a credit

relationship, lenders need such rules in order realistically to

al ae ‘

a oe psc — and the risks and rewards of alternative

Section 1129(b) is just such a definitive rule: reorganizati

value is to be distributed hierarchically from eo aliions

Junior creditors to owners. Alterations are only allowed if the class

adversely affected by the alterations approves. Thus, the Code

leaves it to creditors’ self-interest to alter priorities; no court has

* Amici have examined each of the Reporter

reported (Bankru

post-Ahiers cases in the Courts of Appeals and the oem se hae as ou

forth in the Appendix hereto. None involved any question of insolvency.

”' Indeed, this inefficiency has led to a spiri

chapter 11 maximizes creditor recoveries, var dade cane cage

liquidation, quick sale, or other approach would be preferable. See

generally LoPucki, The Trouble With Chapter 11, 1993 Wis. L. Rev

729, 730-31 nn. 2-9 (reviewing secondary authorities) (hereinafter

LoPucki”). The choice of a litigation system to resolve bankruptcy is

pesats ean iT eoummnies call pen ansountents ar public officials to

"Professor LoPucki has found that, on average, smaller cases take

meee twice as long to reorganize under the Code than ;

under the Act. See LoPucki at 745. sae Lies

» Blum & Kaplan at 653.

20

the power to require classes to so act.” Another feature of Section

1129(b) is that creditors “own” an insolvent business.”* This

ownership includes the right to determine the disposition of both

control of the business,”® which is a key element of reorganization

value, and the business itself. Applied by its terms, Section

1129(b) functions as a clear, fair distribution rule.

B. Recognition Of A New Value Rule Adversely And

Unjustifiably Affects The Lending Process.

1. The Impact Of The New Value Rule.

Even though Section 1129(b) allocates to creditors the value of

control over the debtor, the creditors’ ability to realize on this

value is sharply limited even without a new value rule. The

debtor’s control over the bankruptcy process, its control over

access to information and ability to impose significant costs on

others who seek such access, its centralized decisionmaking, its

ability to use operating funds for legal and other bankruptcy

expenses and to litigate with creditors over distribution issues, its

exclusivity period for filing plans and courts’ willingness readily to

extend that period,” and its strong economic motives to maintain

control and somehow create value for owners, severely affect

* See Kham & Nate's, 908 F.2d at 1360.

> Case, 308 U.S. at 116; Boyd, 228 U.S. at 508. Corporate law

recognizes that “when a corporation becomes insolvent, the fiduciary

duty of directors shifts from the stockholders to the creditors.” FDIC v.

Sea Pines Co., 692 F.2d 973, 976-77 (CA4 1982), cert. denied, 461 U.S.

928 (1983).

% Many decisions recognize that control itself can be a corporate

asset. See, e.g, Periman v. Feldman, 219 F.2d 173 (CA2 1955).

” Many courts routinely extend exclusivity periods. In recognition of

this problem, Congress recently considered legislation with a one year

outside limit. S. 540, 103d Cong., Ist Sess. § 102 (1993). Some judges

believe that chaos will ensue if competing plans are filed. See generally

In re Public Serv. Co., 88 B.R. 521' (Bankr. D.N.H. 1988) (extending

exclusivity, but dismissing debtor’s “chaos” argument); LoPucki at 754-

56. One study found that in 34 of 43 cases of clearly insolvent debtors,

exclusivity continued throughout the case; 27 of the 34 cases lasted for

more than two years. LoPucki & Whitford, Bargaining Over Equity'’s

-f——=

+-

ey *

21

no ability to realize on this element of reorganization

Recognition of a new value rule significantly a nts owners’

ability to retain control of an insolvent debtor, pvy word further

diminishes value accorded to creditors, in complete disregard of

the Code’s statutory scheme. Thus, application of the new value

rule is unsatisfactory because it strips creditors of their Code-

granted power to decide how reorganization value will be allo-

cated, giving that power to the bankruptcy court instead;” the

problem is compounded because the “standards” for applying the

new value rule substitute judicial discretion and case-by-case

analysis for the Code’s very specific distribution rules.” The

Court of Appeals’ approach essentially leaves it to the bankruptcy

Share in the Bankruptcy Reorganization of Large Publicly H

id C

nies, 139 U. Pa. L. Rev. 125, 128 & n.6 (1990). “organ ae

™ See LoPucki at 732-39. Indeed, these issues have led com

-39. mentators

ely ancy em pe | cea or preemptively to exclude insol-

-_ from the confirmation process. See, ¢.g., Markell at 107-11,

14-16; Note, The Bankruptcy Code and the New Value Doctrine: An

Examination into History, Illusions, and the Need for Competitive

Bidding, 79 U. Va. L. Rev. 917, 948-56 (1993); LoPucki & Whitford,

Preemptive Cram Down, 65 Am. Bankr. L.J. 625 (1991).

ys

Kham & Nate's, 908 F.2d at 1360 (the new value exception “means

4 power in the judge to ‘sell’ the stock to the managers even when the

creditors believe that this transaction will nor augment the value of the

firm”) (emphasis in original).

«© }

See In re Il] Joint Venture, 995 F.2d 1274, 1284 (CAS

elaborate ground rules for achieving consensual plans.”

: ), corrected,

reinstated, reh'g denied, 995 F.2d 1284 (CAS 1991), cert. denied, 113 S.

Ct. 72 (1992). One effect of the Court of Appeals’ decision below may

be to immunize new value determinations from effective appellate

scrutiny because of the difficulties in reviewing decisions balancing

multiple factors which tend to be highly discretionary and subjective

and the failure to tie the factors to any verifiable bankruptcy policy.

22

court to work out the details, thereby encouraging fencing, bluff-

ing, posturing, and all the attendant problems of litigation — all to

resolve a basic issue which Congress already has decided. Ulti-

mately, the procedure contemplated by the Court of Appeals

would increase costs and delay resolution.

The problem is exacerbated in many cases where owners

attempting to use the new value rule propose plans containing

other mechanisms which undermine creditors’ rights, such as

classifying claims in such a way as to guarantee the necessary

accepting class required by Section 1129(a)(10).“' These various

devices have often resulted in insolvent debtors proposing plans

which are opposed by the creditors who have the overwhelming

economic interest in the debtor, and which negate the protections

accorded by Congress in Section 1129(b).

For creditors, the introduction of a new value rule lowers

predictability, increases costs, and ultimately forces concessions

to owners. Thus, the creditor confronted with a debtor’s proposed

new value plan must either oppose the plan and/or try to confirm

a competing plan (which the owners will oppose). There is little

downside or cost to the owners, since they are already “out of the

money.” By contrast, the creditor must fund not only the costs of

its own litigation, but since the debtor is insolvent, the owners’

costs in seeking to confirm their plan.” Bankruptcy expenses

continue while the litigation goes on, and the creditor faces the

real risk of an erosion of the value of the business and a

concomitant decline in reorganization values.””

Given the vagaries of the new value rule, no lawyer can assure a

creditor client of certain, or even probable, victory in the litiga-

“' Greystone, 995 F.2d at 1277; In re Bryson Properties XVIII, 961

F.2d 496, 501 (CA4), cert denied, 113 S. Ct. 191 (1992).

“ The owners’ costs are usually intluded in the debtor's legal fees;

owners rarely retain and compensate their own counsel.

“ Business rarely improves in bankruptcy, once some initial stabiliza-

tion takes place. Moreover, owners and managers of insolvent enterprises

have “powerful economic incentives . . . toward reckless, high risk, short

term investment policies.” LoPucki at 732.

en es

process

hardiest creditor is inclined to eschew the fight and give up some

value to owners.“ This is, of course, precisely what is not

pposed to happen under Section 1129(b) and the decisions of

this Court applying the “fair and equitable” doctrine.

2. The Stated Rationales For The New Value Rule Are

Specious.

None of the policies articulated by proponents of the new value

b. Reorganization. A second attempted justification for a

new value rule is that the debtor needs the owners’ contribution to

“Skeel, The Uncertain State of an Unstated Rule: Bankruptcy’

Comobution Rule After Ablers, 63 Am. Banks. L. J. 221, 246-4

“ Eg. Markell at 107-111.

“ The Court of Appeals implied that the i

opportunity to provide new

value need not be extended to creditors or third parties. 2 F.3d at 910-11.

” Kham & Nate's, 908 F.2d at 1360; Greystone, 995 F.2d at 1284. The

bankruptcy court can always disallow votes cast in bad faith. See 11

U.S.C. §1126(e).

24

reorganize. This rationale fails as well: contrary to the Court of

Appeals’ opinion below, there is no reason to prefer a specific

form of reorganization which permits owners to contribute funds

and retain their ownership interests, or even to reorganize at all. If

reorganization is the best economic alternative and new funds are

required for continuing operations or capital expenditures, it

should be possible to convince creditors to vote for a plan which

either provides new value from owners in exchange for stock, or

contemplates that creditors will put up the contributions them-

selves, or proposes a mechanism to raise the funds from a third

party.

Presuming that reorganization using owners’ funds is a pre-

ferred result, and that creditors opposing this result are merely

being obstructionist, obscures the fact that disputes over new

value are usually disputes over business issues such as the need

for new money, the amount needed, the ability to obtain funds in

other ways, the amount of equity a new contribution should buy,

or even the wisdom of reorganization itself. The Code does not

give bankruptcy courts the power to resolve such business issues

in favor of reorganization, but has left them to resolution throug:

negotiations over distribution of reorganization value under the

plan. In the context of those negotiations, the Code gives creditors

the choice between the best deal they can negotiate and the

treatment they are entitled to under Section 1129(b). If negotia-

tions fail, the court has no roving power to impose a solution on

creditors or to require reorganization.

c. Access to Capital Markets. Yet another purported justifi-

cation for recognition of a new value rule is that it enhances

reorganizing debtors’ access to the capital markets.“ Yet as

noted, most cases in which courts actually have applied the new

value rule involve “single asset” real estate, farms or small,

closely-held corporations. Although “access to the capital mar-

“See generally Warren, A Theory of Absolute Priority, 1991 Survey of

American Law 9, 14-16 (1991).

ed

25

kets” has an appealing ring, it has little relevance to these cases,

which do not involve attempts to sell a complex enterprise.”

d. Creditor Plans. Finally, it has been argued that there is

no harm in allowing debtors to take advantage of a new value rule,

as creditors who disagree on the optimal shape of the reorganiza-

tion can propose their own plan. Indeed, many commentators, and

the influential National Bankruptcy Conference, believe that

some assurance that creditors facing new value plans will be able

to file their own plans is the solution to problems with the new

value rule.”

This proposal has a number of flaws. First, creditors’ ability to

file their own plans is not a substitute for the certainty to which

they are entitled under Section 1129(b). Second, proposing a

competing plan merely exacerbates the litigation issues discussed

earlier. Third, if both the creditor’s plan and the debtor’s plan are

accepted, the bankruptcy court will have to choose one to con-

firm, and Section 1129(c), which governs the court’s choice and

requires the court to take into account creditors’ and equity

security holders’ preferences, offers no guidance as to which plan

should be approved in this situation.

Finally, preparing a creditor's plan is difficult for even the

largest and best-financed creditors, given the lack of access to

a creditor’s plan is significantly more expensive than opposing a

plan proposed by the debtor which does not comply with Section

1129(b), and there are many creditors who actively participate in

cases and negotiate over plan treatment who cannot devote

sufficient resources to prepare, file, and litigate creditor plans.

Moreover, it is not an “either-or” proposition: a creditor proposing

its own plan must still oppose the debtor’s plan.

“Single asset real estate debtors usually have little or no going

concern value.

® See ALI-ABA Conference, Bankruptcy Reform Circa 1993, A

Presentation of the National Bankruptcy Conference's Bankruptcy Code

Review Project 253-55 (1993), Note, supra note 38, at 947-51 & n.193

(citi horities).

26

3. Summary.

The Court of Appeals’ decision defies certainty and promotes

litigation. Application of a new value rule delays resolution, allows

owners which are often “out of the money” to prolong the process,

and deprives creditors of their statutory choice between the best

deal they can make with the debtor and their minimum entitle-

ment under Section 1129(b), compelling them instead to choose

between the costs of delay and the uncertainties of litigation, on

the one hand, and the cost of buying peace, on the other hand.

These practical concerns frequently compel settlements that re-

sult in a transfer of reorganization value to owners, and increase

the overall cost of credit — an increase which must be passed on

to all borrowers. |

V. The Plain Meaning Principle Precludes Recognition

Of A New Value Rule.

Adoption of the new value rule is precluded by the “plain

meaning” principle, as articulated in this Court’s recent decisions

holding that pre-Code practice and legislative history are of only

marginal relevance in interpreting the Code. In United States v.

Ron Pair Enters., Inc., 489 U.S. 235, 240-242 (1989), this Court

held that in the context of a comprehensive statutory scheme that

comprises a substantial overhaul of prior law, the plain meaning

of the statute should control unless a clearly unintended result

would ensue. Although this Court has rendered a number of

subsequent bankruptcy decisions, each — properly interpreted —

reflects the standard set forth in Ron Pair.”

5! See, e.g. Patterson v. Shumate, 112 S. Ct. 2242, 2247 (1992)

(“plainly read, [Section 541 (c) (2) ] encompasses any relevant nonban-

kruptcy law, including federal law such as ERISA”); Dewsnup v. Timm,

112 S. Ct. 773 (1992) (pre-Code practice relevant only where provision

at issue ambiguous); Union Bank v. Wolas, 112 S. Ct. 527, 531 (1991)

(“{T]he fact that Congress may not have foreseen ali of the conse-

quences of a statutory enactment is not a sufficient reason for refusing to

give effect to its plain meaning”); Toibb v. Radloff. 111 S. Ct. 2197,

2200 (1991) (legislative history is irrelevant unless the statute is

unclear); Pennsylvania Public Welfare Dept. v. Davenport, 495 U.S.

27

A. Language Of Section 1129(b) (2).

Under Section 1129(b), a plan can be confirmed over a class’

rejecting vote if various requirements are satisfied. A basic

principle of Section 1129(b) is that the plan must be “fair and

equitable” with respect to each dissenting impaired class. For a

class of unsecured creditors, Section 1129(b)(2) requires the

court to find that either they will be paid in full or that no junior

claimant will receive any value under the plan “on account of” its

claim, and does not provide any power to vary its provisions on

equitable grounds or to recognize additional bases for cramdown.

By contrast, other sections of the Code, such as Sections 361 and

552(b), specifically include equitable or value-based provisos and

exceptions. :

B. The Court Of Appeals Misread The “On Account Of” And

Includes” Language Of Section 1129.

The Court of Appeals below held that the plai language o

Section 1129(b) (2) (B) (ii) — and in whine nage proviso ‘o

account of” — was not inconsistent with recognition of a new

value rule. The court reasoned that in a new value plan, owners

are not receiving property under the plan “on account of” their

prior ownership interests, but are receiving such property on

account of their contribution of “new value.” 2 F.3d at 908-11.

This argument is flawed. Even the Court of Appeals recognized

that “in some larger sense the reason \...t former owners receive

new equity interests in reorganized ventures is that they are

former owners.” 2 F.3d at 909. In fact, what owners seek is the

exclusive right to propose a new value plan, and the exclusive

right to have such a plan confirmed over the objections of

creditors. These exclusive rights are value received “on account

of the prior ownership interests, as is the ownership interest

received under a new value plan.

The Court of Appeals attempted to avoid the conclusion that a

new value plan inevitably gives owners an interest in property “on

account of” their equity interests by constructing a distinction

552, 563 (1990) (Court refused to resort to pre-Code practice here

Congressional intent was clear from terms of statute). ?

28

between “direct or immediate causation” and “a more remote

variety.” 2 F.3d at 909. This distinction is completely unsupported

by any of the statutory language or legislative history.”

The Court of Appeals also relied on the word “includes” in the

prefatory language in subsection 1129(b)(2) as leaving room for

judicial “legislation” of the new value rule. 2 F.3d at 912. This

reasoning is directly contradicted by the Ahlers case, where this

Court stated that “a reorganization plan in which [debtors] retain

an equity interest in the farm is contrary to the absolute priority

rule.” 485 U.S. at 202. Although Section 102(3) provides that the

word “includes” is not limiting, it should not be read to permit an

exception directly contrary to a statutory rule.

C. The Court Of Appeals Misinterpreted Dewsnup And

Davenport To Create A Rule Overly Deferential To

Pre-Code Practice.

The Court of Appeals announced the following rule of statutory

construction: “Once it has been shown that Congress was aware

of a pre-Code practice, the remaining inquiry under Dewsnup and

Davenport is whether it has made clear its intent to change that

practice.” 2 F.3d at 912. This “rule” is contrary to Ron Pair and

its progeny, contrary to settled principles of statutory construc-

tion, and even contrary to the Dewsnup and Davenport decisions

themselves, properly interpreted.

In Dewsnup, this Court used pre-Code practice as a guide to

Congressional intent given manifest ambiguity in Section 506(d),

In misinterpreting the “on account of” language, the Court of

Appeals also misapplied the traditional principle of statutory construc-

tion that “a Court must give effect, if possible, to every clause and word

of a statute,” 2 F.3d at 908, and suggested that the “on account of”

language would be “superfluous” if there were no new value rule. 2 F.3d

at 909. This statement overlooks an obvious meaning for the “on

account of such junior claim or interest” phrase. Without the phrase, an

entity which happened to hold both a senior claim and a junior claim (or

interest) would be barred from receiving any property under the plan,

even though other holders of senior claims would receive property under

the plan. The “on account of” language simply avoids the absurd result

of penalizing the holder of a senior claim for also holding a junior claim.

29

which seems to permit a debtor to “strip down” liens to the value

of the underlying property. This Court noted that such an inter-

pretation directly contradicts the legislative history of Section

506(d), which states that such section permits liens to pass

through the bankruptcy case unaffected. 112 S. Ct. at 779. Such

an interpretation also contradicts the general structure of the

Code for numerous reasons: (1) it operates as an avoiding power,

although all other avoiding powers are specified in Subchapter III

of the Code, (2) it overlaps and somewhat overrides carefully

balanced provisions in Section 522, and chapters 11, 12, and 13

dealing with the treatment of undersecured claims (i.e., claims

exceeding the value of collateral), and (3) it conflicts with the

redemption provision of Section 722. Unlike in Dewsnup, here

there is no legislative history or statutory framework supporting

the new value rule which is inconsistent with the provisions of

Section 1129(b).

The Court of Appeals cited Davenport for the proposition tha

“[t]he Bankruptcy Code should not be read to abandon ao

bankruptcy practice absent a clear indication that Congress in-

tended to do so.” 2 F.3d at 912. In relying on this one

taken out of context, however, the court ignored the holding in

Davenport. In Davenport, this Court held that criminal restitution

obligations are dischargeable debts under chapter 13, because

they constitute “debts” under the plain language of Section

101 (11). This Court refused to resort to pre-Code practice,

concluding that Congressional intent was clear. This principle

applies equally to the construction of Section 1129(b).

D. The Legislative History Shows That Congress Rejected

New Value Rule. -™

Even if Section 1129(b) (2) (B) (ii) is held to be “ambi *

the legislative history shows that Congress did not oo,

the new value rule into law. Congress explicitly adopted the

absolute priority rule, and the legislative history of the statute

supports an unqualified absolute priority rule.*’ Moreover, Con-

” House Report at 413 (“The general principle of the subsection

permits confirmation notwithstanding non-acceptance by an impaired

class if that class and all below it in priority are treated according to the

30

gress clearly was familiar with Chapter XI of the Act, which

contained no absolute priority rule, and did not enact any such

requirement in chapters 12 or 13.

Further, the Commission Report contained an express and

detailed proposal for codifying the new value exception. Commis-

sion Report at 242. The court below, in a counterintuitive use of

legislative history, used Congress’ rejection of the proposal to

support the new value rule. 2 F.3d at 912. The more natural

interpretation of Congress’ rejection of the proposal is that Con-

gress rejected the new value rule.™

CONCLUSION

For the reasons stated herein, this Court should hold that

Section 1129(b) does not embrace or incorporate a new value

rule, and that a new value rule is inapplicable in chapter 11 cases

under the Code.

Respectfully submitted,

Of Counsel: JONATHAN M. LANDERS*

KATHRYN A. COLEMAN

Grecory J. CONKLIN

LINDA L. CurRTIS

DESMOND J. CUSSEN

GiBSON, DUNN & CRUTCHER

1 Montgomery Street

MICHAEL F. Crotty San Francisco, CA 94104

AMERICAN BANKERS ASS’N (415) 393-8200

1120 Connecticut Avenue, NW Attorneys for Amici Curiae

Washington, DC 20036 *Counsel of record

CHRISTOPHER E. CHENOWETH

CALIFORNIA BANKERS ASS’N

455 Market Street, 17th Floor

San Francisco, CA 94105

absolute priority rule. The dissenting class must be paid in full before

any junior class may share under the plan.”’)

“The Commission’s proposal was itself the subject of scholarly

debate and was criticized as inconsistent with the absolute priority rule,

thus weakening the “adoption by silence” argument. See, e.g, Blum &

Kaplan at 667-72.

THE APPENDIX INCLUDED HEREIN HAS BEEN REPRODUCED

AND SEPARATELY LODGED WITH THE CLERK OF THIS COURT

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Addendum |

The New York State Bankers Association (“NYSBA”) is the

principal trade association for the commercial banking industry in

New York State. Its 150 domestic and non-resident member

banks collectively hold nearly $700 billion in assets and employ

170,000 persons in the State. The NYSBA’s members, most of

which are actively engage¢ in the business of making both

secured and unsecured loans, aclude some of the largest banking

organizations in the United States.

From time to time as appropriate the NYSBA appears as amicus

curiae in cases that raise significant questions of law affecting the

commercial banking industry and which have a direct, substantial

and continuing impact on its members. This is such a case. This

Court’s determination of the issues presented in this appeal

unquestionably will have a profound effect on the conduct of

secured lending business by NYSBA member banks, both in New

York State and elsewhere throughout the United States.