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

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No. 93-714 )

In The

Supreme Court of the United States

October Term, 1993

U.S. BANCORP MORTGAGE COMPANY,

Petitioner,

Vv.

BONNER MALL PARTNERSHIP,

Respondent.

On Writ Of Certiorari

To The United States Court Of Appeals

For The Ninth Circuit

MOTION FOR LEAVE TO FILE A BRIEF AS AMICUS

CURIAE AND BRIEF OF THE AMERICAN COLLEGE OF

REAL ESTATE LAWYERS AS AMICUS CURIAE

IN SUPPORT OF PETITIONER

Counsel of Record:

Of Counsel:

Paut A. Roserts Pror. Rosert M. ZINMAN

President, American College St. John’s University

of Real Estate Lawyers School of Law

8000 Utopia Parkway

THomas C. HomBuRGER

Co-Chair, Amicus Briefs Jamaica, New York 11439

(718) 990-6646

Committee, American College Cc ; : ‘efs

of Real Estate Lawyers eco Anton Dele

Committee, American College

Pror. WALTER J. TAGGART of Real Estate Lawyers

Chair, Bankruptcy CuristorHerR F. GRAHAM

Committee, American College Tsacuer, Pacrerrtr & Wooo

of Real Estate Lawyers 2 World Trade Center

MicnHaet S. KHoury New York, New York 11048

Davip Foster (212) 912-7400

CLARK, Kien & BEAUMONT

EUGENE YAMAMOTO

LaANpvets, Riptey & DiaAMOoNnND

CuHrIsTINA L. FEEGE

THACHER, Prorrrrr & Woop

RE ______ —_seeseeeseseEeeeeeeeseseseeseseseeseseseseseseseseese

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

OR CALL COLLECT (402) 342-2831

(44

No. 93-714

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

MOTION FOR LEAVE TO FILE A

BRIEF AS AMICUS CURIAE

The American College of Real Estate Lawyers

(“ACREL”) by and through their undersigned attorney

hereby respectfully moves this Court for leave to file the

attached amicus curiae brief in support of U.S. Bancorp

Company (the “Petitioner”) in the above captioned mat-

ter (the “Appeal”) and respectfully represent as follows:

Consent of Parties

The consent of the attorney for the Petitioner has

been obtained. A letter evidencing such consent is

attached hereto as exhibit A. The consent of the attorney

for the Respondent was requested but refused.

Interest of the Amicus Curiae

I. ACREL is a non-profit corporation organized for the

purpose of gathering together lawyers to improve and

reform real estate law. ACREL’s membership consists of

approximately 800 attorneys from nearly ever state and

the District of Columbia who have concentrated their

practice in real estate law for a period of ten years or

more, and law professors specializing in the field of real

estate law. The case at bar involves a single asset debtor

owning commercial real estate.

II. ACREL believes that the decision of the Ninth Cir-

cuit, if upheld, will have serious adverse affects upon the

availability of financing for the acquisition and develop-

ment of commercial real property in the United States.

III. ACREL therefore has an interest in presenting to the

Court the view that in the broad context of public policy

and future economic development, the interpretation of

the Bankruptcy Code advanced by the Ninth Circuit is

erroneous and should be overruled.

The Proposed Amicus Curiae Brief

IV. A copy of the proposed amicus curiae brief is submit-

ted herewith. The proposed brief focuses on legal and

policy arguments not made in the brief of the Petitioner.

Conclusion

Due to the Amicus’ substantial interest in the out-

come of the Appeal and due to the importance of the

issues presented, the Amicus hereby requests that their

motion for leave to file an amicus curiae brief in the

Appeal be granted.

Dated: New York, New York

February 22, 1994

Respectfully submitted,

CHRISTOPHER F. GRAHAM Proressor Ropert M. ZiINMAN

THACHER Prorritt & Woop St. John’s University

Two World Trade Center School of Law

New York, New York 10048 8000 Utopia Parkway

(212) 912-7400 Jamaica, New York 11439

(718) 990-6646

Attorneys for American

Counsel of Real Estate

Lawyers

No. 93-714

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

BRIEF OF THE AMERICAN COLLEGE

OF REAL ESTATE LAWYERS AS AMICUS CURIAE

IN SUPPORT OF PETITIONERS

QUESTION PRESENTED

1. Whether the “new value exception” to the “abso-

lute priority rule” survived the codification of a modified

absolute priority rule under §1129(b)(2)(B)(ii) of the

Bankruptcy Code, which does not reflect such exception?

2. Assuming, arguendo, the existence of a “new

value exception” did the Ninth Circuit properly apply

such exception?

TABLE OF CONTENTS

2 Page

QUESTION PRESENTED. ...... 0.605560 0 ss seen eens i

TABLE OF AUTHORITIES ...... 6.055600 eee e ee eeees iv

STATEMENT OF INTEREST OF AMICUS CURIAE... 1

SUMMARY OF ARGUMENT........ 5.560000 0ee eee 2

ARGUMENT

Il. “NEW VALUE EXCEPTION” DOES NOT

SURVIVE THE ENACTMENT OF THE

BANKRUPTCY CODE...... 26.6660 6 0 eee ues 3

A. Relevant Statwtes .....cccccccccccceses 3

B. Origin of the “New Value Exception”

Under Prior Law.............0eeeeeees 7

C. Congress Revises the Absolute Priority

DOD, c occcccccdasasesoscepseessegeess 9

ll. THE ADOPTION OF THE “NEW VALUE

EXCEPTION” BY THE NINTH CIRCUIT

AND ITS APPLICATION TO SINGLE ASSET

REAL ESTATE REORGANIZATIONS IS A

DISTORTION OF THE “NEW VALUE

EXCEPTION” AND ABROGATES THE

ABSOLUTE PRIORITY REQUIREMENTS OF

THE BANKRUPTCY CODE...........----- 11

Ill. THE NINTH CIRCUIT’S APPLICATION OF

THE “NEW VALUE EXCEPTION” IS CON-

TRARY TO THE EXPRESS PROVISIONS OF

§1129(B)(2) OF THE BANKRUPTCY CODE... 15

TABLE OF CONTENTS - Continued

Page

A. Under the “New Value Exception” as

Articulated by the Ninth Circuit, The

Holder of the Secured Claim Will Not

Receive the Allowed Amount of its

Claim as Required by §1129(b)(2)(A)(i)

of the Bankruptcy Code............... 15

B. Under the “New Value Exception” as

Reformulated by the Ninth Circuit, the

Debtor Will Retain an Interest Without

Providing the Unsecured Creditors with

Property of a Value Equal to the Allowed

Amount of their Claims Contrary to the

Express Language of §1129(b)(2)(B) .... 16

IV. THE APPLICATION OF THE “NEW VALUE

EXCEPTION” TO SINGLE ASSET REAL

ESTATE REORGANIZATIONS SERVES NO

PUBLIC PURPOSE AND ABROGATES THE

PROTECTION FOR THE MORTGAGEE

BUILT INTO THE BANKRUPTCY CODE... 18

A. No Public Purpose.................... 18

B. Abrogation of Mortgagee Protection.... 19

fe GE DENS cov vcedeccctcceses 19

2. Treatment of Absolute Priority

Under the Bankruptcy Code ....... 22

V. IF THE NINTH CIRCUIT’S DECISION IS

ALLOWED TO STAND, IT WOULD HAVE A

SEVERE AND NEGATIVE IMPACT ON BOR-

ROWERS, LENDERS AND THE REAL ESTATE

Ey toe covbbesenuepuesédverestecevevs 24

SE hee beecbesnweGbucssotortddoketiercee 25

TABLE OF AUTHORITIES

Page

CASES

Case v. Los Angeles Lumber Product Co., 308 U.S. 106

CORED onc 00-068 oeebetssene seu beeisedbsaedesacs passim

Caminetti v. United States, 242 U.S. 855 (1917) ........ 6

Dewsnup v. Timm, 112 S. Ct. 773 (1992)........... 10, 11

In re KRO Associate, 4 Bankr. Ct. Dec. (CCH) 462

anion. GAIL. - BGG 66 6608 ecWeseeseedsercccecens 22

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

(eer rrr errr rere nr errr to per re 13, 20

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

CRUD coved dwsdicdsenctcbivendscnaeenenades 11, 14, 24

In re Outlook/Century Ltd., 127 B.R. 650 (Bankr.

DER Gee, FRE vc cc cccccccddewevdasscoutacvess 14, 20

In re Pine Gate Associates, Ltd., 2 Bankr. Ct. Dec.

(CCH) 1478 (Bankr. N.D.Ga. 1976) ......... 21, 22, 24

United States v. Ron Pair Enterprises, Inc., 489 U.S.

Be CE nn va cu cncdecavsessucnackcaussesnsccccnecs 6

STATUTES

BD UG. GOD «oc ccc ccivvsrcrcvnvdccesccscudec passim

BE CRE, BGs coc odic cccvevedivecvscedeccsucntyn tvs 4

BE DBL. BER cc ccccccacedwevdetandeseens suseuncc 4

BA WG. Bee cc ccesccccccnccecsesouestvcescan passim

TABLE OF AUTHORITIES —- Continued

Page

MISCELLANEOUS

Broude, Cramdown and Chapter 11 of the Bankruptcy

Code: The Settlement Imperative, 39 BUS. LAW

PMT ET Tore Tre rrr rt er er ree 21

Brudney, The Bankruptcy Commission's Proposed

“Modification” of the Absolute Priority Rule, 48

Aa, TE. Gas Ss SOE GE nb va ccbcdonetédcies

5 Collier on Bankruptcy (L. King 15th Ed. 1986) ....

Collier Real Estate Transactions and the Bank-

ruptcy Code (L. Cherkis 1985)....................

Note, The Proposed Bankruptcy Act: Changes in the

Absolute Priority Rule of Corporate Reorganiza-

tions, 87 Harv. L. Rev. 1786, 1817 (1974)...........

Report of the Commission on the Bankruptcy

Laws of the United States (H.R. Doc. No. 137,

Parts I and II, Cong., Ist Sess. (1973)) ............

S. Rep. No. 989, 95th Cong. 2d Sess. 65, reprinted in -

1978 U.S. Code Cong. Admin. News 5851.........

Salvatore G. Gangemi and Stephen Bordanaro,

New Value Exception: Square Peg in a Round Hole,

1 Am. Bankr. Inst. L. Rev. 173, 194 and n.130

PRA AS66555 CARAS Od capa SAS ee deueEdEs went eeses

STATEMENT OF INTEREST OF AMICUS CURIAE

The American College of Real Estate Lawyers

(“ACREL”) is a nonprofit corporation, organized for the

purpose of, inter alia, gathering together lawyers “to

improve and reform real estate law and practice.”

(ACREL Articles of Incorporation at 2). ACREL’s mem-

bership consists of over 800 attorneys from nearly every

state and the District of Columbia who have concentrated

their practice in real estate law for a period of ten years

or more and law school professors specializing in the

field of real estate law. In addition, members elected to

ACREL must have demonstrated a willingness to devote

time to improving real property law through writing,

teaching or participation in professional association activ-

ities. ACREL’s membership represents the entire spec-

trum of the real estate industry including borrowers,

lenders, investors and developers. The case at bar - like

almost all cases under the 1978 Bankruptcy Code involv-

ing the applicability of a “new value exception” to the

present Bankruptcy Code’s requirements for confirmation

of a plan notwithstanding creditor rejection — involves a

single asset debtor owning commercial real estate that

has declined in value to a point where the debtor’s real

estate is worth less than the amount of secured debt on

the property. ACREL is therefore in a position to offer an

unbiased and knowledgeable opinion as to the proper

resolution of the issues now before this Court.

This brief supports the position of the Petitioner in

this case. Due to the background of the Amicus and its

experience as counsel to lenders and borrowers, it is in a

unique position to offer its expertise to this Court con-

cerning the adverse effects caused by an affirmance of the

decision below on the availability of financing for the

acquisition and development of commercial real property

in the United States.

SUMMARY OF ARGUMENT

The Court of Appeals’ decision in In re Bonner Mail

upholding the application of the “new value exception”

to the absolute priority rule is contrary to the express

language of §1129(b)(2)(B) of the Bankruptcy Code and

the intention of Congress. Nothing in the express lan-

guage of the Bankruptcy Code supports the Ninth Cir-

cuit’s conclusion that the “new value exception” survived

enactment of the Bankruptcy Code in 1978 and, in fact,

the plain language of §1129(b)(2)(B) controverts such a

conclusion.

Even assuming, arguendo, that the “new value excep-

tion” is still viable, the Ninth Circuit’s decision neverthe-

less should be reversed, as the Ninth Circuit’s application

of the exception is a distortion of the traditional “new

value exception” for operating businesses created by this

Court in Case v. Los Angeles Lumber. This distortion arises

from the application of the “new value exception” to a

single asset real estate plan, which would allow the

debtor and its principals to keep the assets of the enter-

prise without compensating unsecured creditors, thus

abrogating the absolute priority requirements of the

Bankruptcy Code. In addition, the Ninth Circuit’s articu-

lation of the “new value exception” violates the express

provisions of §1129(b)(2) of the Bankruptcy Code by pre-

venting both secured and unsecured creditors from

receiving the allowed amount of their claims.

As a final matter, the public policy rationale for the

application of the “new value exception”, which is based

on the desire to maintain the going concern’s value of the

debtor’s business and to keep people employed, is inap-

plicable in the single asset real estate context because the

commercial real estate involved will continue in opera-

tion — only the ownership will change. Thus, there is no

public policy rationale to uphold the application of the

“new value exception” in the instant case.

ARGUMENT

I. “New Value Exception” Does Not Survive the Enact-

ment of the Bankruptcy Code.

A. Relevant Statutes.

Nothing in the language of the Bankruptcy Code

supports the Ninth Circuit’s conclusion that the new

value “exception” survived the enactment of the Bank-

ruptcy Code. The Bankruptcy Code contains extensive

provisions governing confirmation of plans of reorgani-

zation by the Bankruptcy Courts. 11 U.S.C. §1129.

Section 1129(b) of the Bankruptcy Code’ details the

limited circumstances under which a Bankruptcy Court

may confirm - or “cramdown” - a plan even if a class of

* 11 U.S.C. §101 et seq. All section references are to the Bank-

ruptcy Code.

creditors has not voted to accept the plan in accordance

with §1129(a)(8).' Under this section, such a plan may be

confirmed despite the non-acceptance of a creditor class

“if the plan does not discriminate unfairly, and is fair and

equitable, with respect to each class of claims or interests

that is impaired under, and has not accepted, the plan.”

11 U.S.C. §1129(b)(1). Unlike the prior Bankruptcy Act,

§1129(b) proceeds to define “fair and equitable” with

respect to particular classes that have not accepted the

plan. Congress chose not to include any “new value

exception” in such definition. Section 1129(b)(2)(B)

requires that for a plan to be “fair and equitable” with

respect to a non-accepting class of unsecured claims

' Pursuant to §1129(a)(8) of the Bankruptcy Code,

each class of claims or interests must either vote to

“accept” the plan or not be “impaired” under the

plan. See generally 11 U.S.C. §1124. Very few bank-

ruptcy cases involve a situation where a class of

unsecured creditors is not impaired under a plan.

Pursuant to §1126 of the Bankruptcy Code, a class of

creditors is deemed to have accepted a plan if such

plan has been accepted by creditors that hold at least

two thirds in amount and more than one half in

number of the allowed claims of such class held by

creditors that have voted to accept or reject the plan.

11 U.S.C. §1126(c). In short, individual dissenting

creditors in a class can be outvoted by similarly situ-

ated creditors thus making possible confirmation of a

plan that has been accepted by the requisite major-

ities. Significantly, the Bankruptcy Act of 1898, as

amended by the Chandler Act of 1938, under which

Case v. Los Angeles Lumber was decided, did not per-

mit creditor majorities to accept a- plan over the dis-

sent of a single creditor in a class. (See discussion

below).

(including a class containing a secured creditor's defi-

ciency claim)? the plan must either (i) provide for full

? Pursuant to §1111(b)(1)(A), a deficiency claim of a non-

recourse lender is treated as a recourse unsecured claim against a

debtor. The subsection provides in pertinent part:

A claim secured by a lien on property of the estate

shall be allowed or disallowed under section 502 of

this Title, the same as if the holder of such claim had

recourse against the debtor on account of such claim

whether or not such holder has such recourse, unless

(i) the class of which such claim is a part elects, by at

least two thirds in amount and more than half in

number of allowed claims of such class, application of

paragraph (2) of this subsection; or

(ii) such holder does not have such recourse and

such property is sold under section 363 of this title or

is to be sold under the plan.

Indicative of Congressional intent is that fact that neither excep-

tion to this rule permits a debtor to maintain the property in

question and pay the secured creditor less than the full amount

of its claim.

Section 506(a) of the Bankruptcy Code provides that any

such deficiency claim “is an unsecured claim”. The section pro-

vides in pertinent part:

“An allowed claim of a creditor secured by a lien on

property in which the estate has an interest, or that is

subject to set-off under section 553 of this title, is a

secured claim to the extent of the value of such credi-

tor’s interest in the estate’s interest in such property,

or to the extent of the amount subject to set-off, as the

case may be, and is an unsecured claim to the extent

that the value of such creditor’s interest or the

amount so subject to set-off is less than the amount of

such allowed claim.” 11 U.S.C. §506(a).

Consequently, a deficiency claim of an undersecured creditor is

accorded the treatment of an unsecured claim and is normally

classified together with other unsecured claims.

payment on such claim or (ii) the holder of any claim or

interest junior in priority to the claims of such class will

not receive or retain under the plan on account of such

junior claim or interest any property. 11 U.S.C.

§1129(b)(2)(B) (emphasis added). As explained below, the

statutes detailing confirmation and voting provisions do

not contain any exception to this absolute priority rule in

the case of a plan seeking confirmation over the non-

acceptance of a creditor class. The “new value exception”

to the absolute priority rule recognized by the Ninth

Circuit below permits the owners of a debtor to retain the

ownership of all the property of the debtor without pay-

ing in full the claims of the unsecured creditors — includ-

ing the deficiency claims of secured creditors who would

prefer to own the property and realize any later apprecia-

tion. The language of the Bankruptcy Code permits no

such result.

There is no mention in the Bankruptcy Code of any

exception to the clear and precise plan confirmation

requirements of §1129(a) and §1129(b)(2)(B), which are

unequivocal, without exception, and must be enforced as

written. United States v. Ron Pair Enterprises, Inc., 489 U.S.

235, 241, (1989) (where the statute’s language is plain the

sole function of the court is to enforce it according to its

terms) (quoting Caminetti v. United States, 242 U.S. 855

(1917)).

Indeed there is no reason for the “new value excep-

tion” to be applicable under the Bankruptcy Code since,

as established below, the drafters of the Bankruptcy Code

addressed and cured the problem giving rise to the adop-

tion of the “new value exception”.

B. Origin of the “New Value Exception” Under

Prior Law.

The “new value exception” was judicially fashioned

in response to the strict requirements of the corporate

reorganization provisions of prior law, specifically §77B

of the Bankruptcy Act of 1898 and its successor Chapter X

of the Chandler Act of 1938. 5 Collier on Bankruptcy at

1100-1108, | 1101.01[2] (Lawrence P. King ed. 1993). In

order to protect individual dissenting creditors within

accepting classes, it was provided that a plan could not

be confirmed unless the plan was approved by the requi-

site majority of each class and judicially determined to be

fair and equitable, i.e. met the absolute priority require-

ments.* As a result, notwithstanding approval of the plan

by the requisite majorities of members of each class of

creditors, a plan designed by senior creditors to motivate

and keep effective management by giving the prior

owners/managers an equity interest in the reorganized

enterprise could not be confirmed if a single creditor

objected.

In Case v. Los Angeles Lumber Prod. Co., 308 U.S. 106

(1939), the debtor (with overwhelming creditor support)

attempted to circumvent this strict rule by arguing that

* In short, in contrast to the present Bankruptcy Code con-

firmation requirements which are disjunctive, viz., class accep-

tance or fair and equitable, the prior Bankruptcy Act

requirements were conjunctive — class acceptance and fair and

equitable. Under the present Bankruptcy Code, individual dis-

senting creditors are protected by, inter alia, the best interests of

creditors test contained in 11 U.S.C. §112%a)(7).

the old stockholders were paying for their retained inter-

est in the reorganized entity by contributing their experi-

ence, contacts and management ability. This court

rejected that argument stating that old equity could par-

ticipate only if they paid for their interest in “money or

money's worth” (/d. at 122). Thus this court created what

became known as the “new value exception” to the abso-

lute priority rule, under which junior interests (e.g. stock-

holders) could contribute new capital to a bankruptcy

plan in exchange for an interest in the reorganized enter-

prise equal to the value of their contribution. Actually

this is not an “exception” to the absolute priority rule, it

is in fact an affirmation of the requirement of absolute

priority and a rejection of attempts at “easy evasion of the

principle of full or absolute priority” Id. (citations omit-

ted)

Obviously, requiring payment of money for the inter-

est was not the bargain that the senior creditors or old

stockholders had in mind in the rejected plan in Los

Angeles Lumber. They had agreed on equity participation

without any payment. Los Angeles Lumber’s “new value

exception” did not solve the problem of the absolute

priority rule permitting a single creditor to veto the plan

approved by the requisite majorities of those who had an

interest in the firm. When the Bankruptcy Code was

being drafted, numerous suggestions were made for leg-

islative changes that would deal with the problem by

overcoming the rigid absolute priority requirements of

Chapter X.

=_-

C. Congress Revises the Absolute Priority Rule.

On July 24, 1970, then President Nixon appointed the

Commission on the Bankruptcy Laws of the United States

(“Commission”) to consider a review of the Bankruptcy

Act. The Commission completed its work in July 1973

after an extensive study and submitted its Report (“Com-

mission Report”) containing a proposed new bankruptcy

law. The Commission Report discussed the nature, devel-

opment, justification and deficiencies of the absolute pri-

ority rule, noting that it had become a “straight jacket”

since und’ - it, equity security holders could not partici-

pate - even by agreement of all classes of creditors.

Commission Report, Part I, at 256-57. The Commission's

solution was to modify the absolute priority rule by

permitting juniors who make a contribution important to

the operation of the reorganized debtor to participate on

a basis reasonably approximating the value of their con-

tribution.*

* The Commission Bill (H.R. Doc. No. 137, Parts I and II,

Cong., 1st Sess. (1973) provided in §7-303(4) that the plan of

reorganization:

may provide, if the court finds that . . . certain part-

ners or equity security holders will make a contribu-

tion which is important to the operation of the

reorganized debtor or successor under the plan, for

participation by the individual debtor, such partners,

or such holders under the plan on a basis which rea-

sonably approximates the value, if any, of their inter-

ests and the additional estimated value of such

contribution.

This proposal created a storm of controversy® and

was rejected by Congress. In its place, Congress modified

the absolute priority rule in a different way, presently

reflected in §1129 of the Bankruptcy Code, under which

each class is free to agree by the requisite majority to

accept a plan that affords the class less than absolute

priority. Only where an impaired class rejects the plan is

it entitled to absolute priority treatment. If §77B and

Chapter X of the former Bankruptcy Act had contained a

similar provision, the issue in Los Angeles Lumber, which

gave rise to the creation of the “new value exception”,

would never have arisen.

Thus Congress dealt in a fundamental way with the

problem for which the “new value exception” was devel-

oped. Senior classes of creditors are free to allow junior

class participation if the senior class votes to accept such

a plan. If a senior impaired class does not accept a plan,

absolute priority must be provided or the plan cannot be

confirmed as fair and equitable. See §1129(b)(2)(B)(ii).

Any attempt to obviate the absolute priority requirements

in court imposed plans (so-called “cramdown” plans) has

no validity under the Bankruptcy Code as adopted by

Congress.®

5 See e.g. Brudney, The Bankruptcy Commission's Proposed

“Modification” of the Absolute Priority Rule, 48 Am. Bankr. L. J.

305, 337 (1974) and Note, The Proposed Bankruptcy Act: Changes in

the Absolute Priority Rule of Corporate Reorganizations, 87 Harv. L.

Rev. 1786, 1817 (1974)

* Some courts have argued that this Court’s decision in

Dewsnup v. Timm, 112 S. Ct. 773 (1992) may require a finding that

the new value “exception” survives the enactment of the Bank-

ruptcy Code. This is not correct. While it is true as this Court

II. The Adoption of the “New Value Exception” by the

Ninth Circuit and its Application to Single Asset

Real Estate Reorganizations is a Distortion of the

“New Value Exception” and Abrogates the Abso-

lute ?riority Requirements of the Bankruptcy Code.

As discussed above, given the Bankruptcy Code’s

extensive revisions to plan confirmation requirements,

the “new value exception” has no raison d'etre in the

Bankruptcy Code. Assuming arguendo, this Court con-

cludes that the “new value exception” is still a viable

judicial supplement to Chapter 11, or if this Court

declines to reach the issue of the “exception’s” validity’,

the Ninth Circuit should be reversed because the “new

value exception” — as reformulated by the Ninth Circuit

into the new value principle —- is not the “new value

exception” created by this Court in Case v. Los Angeles

Lumber. In that decision, this Court concluded that a

reorganization plan could permit a junior interest, with

majority creditor consent, to participate in the reor-

ganized entity only to the extent that the junior interest

contributed money or money’s worth to the enterprise.

stated in Dewsnup that Congress does not “write ‘on a clean

slate’ ” when it amends the bankruptcy laws, 112 S. Ct. at 779,

no doctrine requires application of a pre-Code practice devel-

oped to meet a pre-Code requirement that no longer exists. As

discussed above, it was the restrictive nature of the pre-Code

absolute priority rule that resulted in the creation of the limited

“new value exception”. That restrictive nature has been

removed from the Bankruptcy Code absolute priority provi-

sions. Pre-Code practice cannot be said to survive into a new

law that has eliminated the problem for which the practice was

developed.

7 Norwest Bank Worthington v. Ahlers, 485 U.S. at 203, n.3.

Such participation would not violate the absolute priority

rule because in the context of a multi-asset reorganiza-

tion, no creditor’s interest was adversely affected by the

retention of an interest in exchange for a contribution.

The junior’s contribution “enlarged the pie” of available

assets and the junior was entitled to an interest to the

extent its funds resulted in the enlargement. See Salvatore

G. Gangemi and Stephen Bordanaro, New Value Exception:

Square Peg in a Round Hole, 1 Am.Bankr.Inst.L.Rev. 173,

194 and n.130 (1993).

Under the Ninth Circuit’s version of the “new value

exception”, by making a contribution, the debtor's princi-

pals can keep the property — free of the interests of

unsecured creditors including the mortgagee’s substan-

tial deficiency claim. Instead of enabling the junior inter-

est holder to participate to the extent it enlarges the

“pie”, the Ninth Circuit permits the junior interest to

keep the property in question, and any subsequent appre-

ciation to the detriment of all unsecured creditors and the

mortgagee’s deficiency claim. This is clearly contrary to

the spirit, language and purpose of the “new value excep-

tion” and this Court’s decision in Los Angeles Lumber.

The reason the Ninth Circuit’s decision so distorts

the “new value exception” is that the “exception” is being

applied to a court imposed single asset real estate plan.

As observed above, the “new value exception” arose in

the context of multi-asset reorganizations where there

was some value to be distributed to creditors. In a single

asset court imposed plan such as the instant case, the

debtor has only one property and that property is worth

less than the debt to the mortgagee. The undersecured

mortgage has been reduced under §1129(b)(2)(A) of the

Bankruptcy Code to the value of the collateral as deter-

mined under §506(a) of the Bankruptcy Code. Since, the

plan reduces the secured creditor’s mortgage to 100% of

the previously court-determined property value, the

debtor’s principals argue that there is no equity for

unsecured creditors. The self-serving alchemy of the plan

is then invoked. Any “substantial” contribution, the

debtor’s principals argue, will be sufficient to enable

them to keep the property and discharge the claims of

unsecured creditors.®

This concept, that if there is no equity in the property,

the creditors have no rights, was specifically rejected by

this Court in Northern Pacific Railway Co. v. Boyd, 228 U.S.

482, 508 (1913) where this Court stated:

“If the value of the [property] justified the issu-

ance of stock in exchange for old shares, the

creditors were entitled to the benefit of that

value, whether it was present or prospective, for

dividends or only for purposes of control. In either

event it was a right of property out of which the

creditors were entitled to be paid before the

stockholders could retain it for any purpose what-

ever.” (emphasis added.)

228 U.S. at 508.

8 The inequity of such a scheme is particularly apparent in

the commercial real estate industry where property values are

affected little by management expertise and cyclical fluctua-

tions are common. The Ninth Circuit’s approach shifts the

downside risk to the lenders.

Control is a property right and whether or not the

court finds equity in the property, the creditors are enti-

tled to the benefit of that control. This principle is embod-

ied within §1129(b)(2)(B) and was specifically endorsed

by this court in Norwest Bank Worthington v. Ahlers, 485

U.S. 197, 207-09 (1989).%

The “new value exception” as reformulated and

applied by the Ninth Circuit takes a rule designed to

protect creditors and converts it to a rule under which the

debtor and its principals can keep the assets of the enter-

prise without compensating unsecured creditors, thus

abrogating the absolute priority requirements of

§1129(b)(2)(B). This violates the Bankruptcy Code and

rule of absolute priority rule as it has long been articu-

lated by this Court.

® See also In re Outlook/Century Ltd., 127 B.R. 650, 656 (Bankr.

N.D. Cal. 1991) where the court recognized that the plain lan-

guage of §1129(b)(2)(B) does not permit any “new value excep-

tion”:

The ‘new value exception’ is inconsistent with the

penciple of creditor control, because it would permit

btor to force the plan of reorganization on creditors

who do not believe that the plan is in their best inter-

est and whom Debtor does not propose to pay in full.

127 B.R. at 657-658 (citations omitted).

III. The Ninth Circuit’s Application of the “New Value

Exception” is Contrary to the Express Provisions of

§1129(b)(2) of the Bankruptcy Code.

A. Under the “New Value Exception” as Articu-

lated by the Ninth Circuit, the Holder of the

Secured Claim Will Not Receive the Allowed

Amount of its Claim as Required by

§1129(b)(2)(A)(i) of the Bankruptcy Code.

Section 1129(b) of the Bankruptcy Code provides that

where a dissenting, impaired class of creditors rejects a

plan, the plan may be confirmed notwithstanding this

rejection by a class only if the plan is “fair and equitable”

as to that class. With respect to secured classes, under

§1129(b)(2)(A)(i), where the dissenting, impaired secured

creditor’s lien is retained under the plan, the plan is not

fair and equitable as to that class if the lien does not have

a value as of the-effective date of the plan equal to the

amount ot the secured claim.

The amount of an undersecured creditor’s claim is

determined under §506(a) which provides that a claim is

a secured claim to the extent of the value of the collateral

and an unsecured claim to the extent that the debt

exceeds the value of the collateral. In the instant case, the

value of the collateral was determined under §506(a) and

the mortgage was reduced to that value. Section 506(a) is

subject to redetermination for various purposes during

the reorganization including a redetermination in connec-

tion with “any hearing . . . on a plan affecting such

creditor’s interest.” 11 U.S.C. §506(a).

The best indicia of the value of real property is what

a person will pay for the property. In the instant case the

debtor's plan proposes that certain of its partners acquire

the property subject to a mortgage equal to 100% of the

earlier §506(a) determined property value upon the pay-

ment of an additional $200,000. In other words, those

partners are willing to buy the property for $200,000 in

excess of the §506(a) value. This indicates that the earlier

valuation is incorrect and that the amount of the allowed

secured claim should be increased to at least the amount

the debtor’s principals are willing to pay for the property. —

Unless the secured claim is increased to that amount, the

secured creditor is being deprived of its interest in the

collateral contrary to the express provisions of

§1129(b)(2)(A).1°

B. Under the “New Value Exception” as Reformu-

lated by the Ninth Circuit, the Debtor Will Retain

an Interest Without Providing the Unsecured

Creditors with Property of a Value Equal to the

Allowed Amount of their Claims Contrary to the

Express Language of §1129(b)(2)(B).

Under §1129(b)(2)(B), for a plan to be fair and equita-

ble as to an unsecured class of creditors, the debtor's

owners may not receive or retain on account of their

‘© The Plan may also be violative of §1129(a)(3), which

requires that the plan be proposed in good faith. Where the

court determines the value of the property under §506(a) based

on information received from the debtor who is in control of the

flow of information concerning the status of the property, and

the debtor later proposes a plan under which the debtor’s prin-

cipals will be given the property for a price in excess of the court

determined value, serious questions arise as to whether the

good faith requirement has been met.

junior interests any property unless all members of a dis-

senting impaired unsecured class receive property equal

to the full allowed amount of their claims.

The debtor’s plan in the instant case provides that

the debtor’s prior owners retain their ownership interest

in the debtor retaining the property while the dissenting

unsecured class receives less than 10% of their claims.

This is a clear violation of the provisions of

§1129(b)(2)(B). The debtor’s principals argue, however,

that they are not retaining the property “on account of”

their old ownership in violation of §1129(b)(2)(B)(ii), but —

are acquiring the interest for value, much as a third party

could acquire the property by bidding for it. What the

debtor ignores is that such acquisition, whether by the

debtor or a third party bidder is not permitted under the

Bankruptcy Code unless the interests of creditors are

protected. The carefully drafted provisions of subsections

(A) and (B) of §1129(b)(2) preclude such acquisition.'' As

'! In Bonner Mall, the Ninth Circuit transmogrifies the “new

value exception” into the “new value principle” which -

is an extra-statutory doctrine that specifically

regulates the conditions under which plans calling for

an infusion of capital by old equity in exchange for

participation in a reorganized debtor may be

confirmed in a cramdown.

2 F.3d at 910, n. 25. The Ninth Circuit acknowledges that “such a

statutory exception does not exist.” ‘d. Yet, it eagerly embraces

as well-established law the concept of a cramdown plan - a

lender’s worst nightmare — by a route not specified by Congress

when it defined fair and equitable treatment. The upshot of the

Ninth Circuit's decision will be that any party unhappy with the

limitations of the present Bankruptcy Code will rummage

through repealed laws hoping to find some helpful doctrine.

The requirements of a fair and equitable plan have been pain-

discussed above, the undersecured mortgage must equal

the value of the collateral. A bid by a third party or by the

debtor would determine the property value and raise the

amount due under the mortgage. In other words, no plan

under which the debtor or a third party keeps the prop-

erty without compensating creditors in full may be con-

firmed over the objection of the unsecured creditor's

class.

Thus the attempt to reformulate and apply the “new

value exception” to cases involving undersecured mort-

gages on single asset properties is prohibited by the

express provisions of the Bankruptcy Code.

IV. The Application of the “New Value Exception” to

Single Asset Real Estate Reorganizations Serves

No Public Purpose and Abrogates the Protection

for the Mortgagee Built into the Bankruptcy Code.

A. No Public Purpose.

The application of the “new value exception” is often

urged as a matter of public policy in order to keep the

debtor in business, preserve the going concern value and

keep people employed. While these objectives may be

valid in connection with multi-asset reorganizations and

industrial corporations, they are wholly inapplicable to

single asset real estate cases.

stakingly articulated by Congress and there is no need to

resurrect judicially created exceptions to an earlier Act's

undefined version of the fair and equitable standard which

exception was not adopted by Congress.

In a single asset real estate transaction, the debtor's

business is the operation of the real property, which is

leased to tenants who occupy space in the building. Such

operation of real estate will be continued no matter who

is the owner of the property. It is a non-sequitur to say

that the “reorganization will fail” if there is no infusion of

new value. The only thing that may fail is the debtor's

principals’ attempt to keep the property without paying

creditors. If the plan cannot be confirmed and no plan

consistent with the language of the Bankruptcy Code can

be proposed, liquidation will follow and the mortgagee

or other purchaser will acquire and operate the property.

Tenants will still occupy space in the property; the ten-

ants’ employees will continue to be employed in the

premises; whoever operates the property will continue to

employ maintenance and other personnel. The question is

not whether the business will continue. The question is

only who will own the property — the debtor’s principals

who have not paid the debtor's obligations to creditors,

or the creditors who have not been paid by the debtor.

The decision below grants exclusive control and any

appreciation rights to the debtor's principals.

B. Abrogation of Mortgagee Protection.

1. Absolute Priority.

The Ninth Circuit ignores the intent of Congress that

reorganization plans be confirmed only if they are “fair

and equitable” as to dissenting impaired classes. The plan

at issue in the instant case is impermissibly unfair and

inequitable with respect to the dissenting creditor class.

The debtor’s principals are permitted to retain the mort-

gaged property in exchange for only a $200,000 capital

contribution while the dissenting creditor is forced to

accept a pro-rata distribution of 300,000 shares of pre-

ferred stock in the new enterprise, which would be val-

ued at $1 per share, in full satisfaction of its deficiency

claim of approximately $3.4 million. In addition, the dis-

senting creditor will receive no interest in the property.

This turns the concept of “risk capital” on its head since

only the lender permanently loses value.

This Court has held that the dissenting creditor's

interest in the debtor is a property right. Northern Pacific

Railway Co. v. Boyd, supra, 228 U.S. at 508. In the instant

case, U.S. Bancorp’s property rights have been violated

by the plan which permits the transfer of the property to

the debtor’s principals. The statutory framework set up

by Congress requires that such decisions be negotiated by

the debtor with its creditors. The absolute priority rule of

§1129(b) is the basic ground rule for that negotiation

process. It levels the playing field between the debtor's

management, which controls the enterprise and its assets,

and the debtor’s creditors who, if the debtor is insolvent

effectively own the enterprise. See In re Outlook/Century

Ltd., supra, 127 B.R. at 650.

Absolute priority is of critical importance to the

mortgage lending industry. Absolute priority for the

unsecured portion of the mortgagee’s claim (the claim of

the mortgagee in excess of the value of the collateral as

determined under §506(a) of the Bankruptcy Code) is the

linchpin in the package of protection designed by Con-

gress to protect the mortgagee from attempts by the

debtor’s principals to keep the property without paying

creditors.

A major purpose of §1129(b)(2)(B) was to overcome

the so-called Pine Gate line of cases that treated non-

recourse mortgagees as the Ninth Circuit treats all mort-

gagees. See In re Pine Gate Associates, Ltd., 2 Bankr. Ct.

Dec. (CCH) 1478 (Bankr. N.D.Ga. 1976). Those cases

under Chapter XII of the former Bankruptcy Act allowed

borrowers to retain the mortgaged property while paying

the non-recourse mortgagee the depressed value of the

collateral, leaving such mortgagee with no compensation

for the amount of the debt exceeding the property value,

no control of the property, and no appreciation potential.

Bonner Mall produces similar but harsher consequences

for mortgagees since under Bonner Mall the mortgagee

receives in lieu of cash equal to the value of the collateral,

only a reduced mortgage in an amount determined by the

court to be equal to the value of the collateral and

deferred payments that the court has determined have a

present value equal to the value of the collateral.

To overcome the Pine Gate inequity, Congress speci-

fically provided in §1111(b)(1) of the Bankruptcy Code

that every undersecured mortgagee would be able to

have an unsecured claim for the debt in excess of the

property value, and that the dissenting, impaired

unsecured class would be afforded absolute priority.

Thus, the debtor would not be able to retain the property

while unsecured debts remain unpaid.'?

12 See 5 Collier On Bankruptcy, { 1111.02[2] (1. King 15th ed.

1986); |. Cherkis, Collier Real Estate Transactions and the Bank-

ruptcy Code,{ 1.11 (L. King ed. 1985); Broude, Cramdown and

Chapter 11 of the Bankruptcy Code: The Settlement Imperative, 39

Under the Pine Gate line of cases, secured creditors

willing to take the collateral in satisfaction of the debt

were not permitted to do so. The plan would be con-

firmed and the secured creditors paid the value of their

collateral which might be significantly less than their

debt.'3? Due to the non-recourse nature of the debt, the

secured creditors would not have had an unsecured claim

for their loss.'4

2. Treatment of Absolute Priority Under the

Bankruptcy Code

As a direct response to the inequity of the Pine Gate

line of cases, Congress was asked to restore absolute

priority to real estate arrangements and to overrule Pine

Gate.'5 Congress responded. It enacted a series of com-

plex provisions as part of the Bankruptcy Reform Act of

BUS. LAW. 441 (1984); and S. Rep. No. 989, 95th Cong. 2d Sess.

65, reprinted in 1978 U.S. CODE CONG. ADMIN. NEWS 5851

(commenting on Section 502(i) in an earlier version of Section

1111(b)).

13 See In re KRO Assoc., 4 Bankr. Ct. Dec. (CCH) 462 (Bankr.

S.D.N.Y. 1978), where there were approximately $14 million in

mortgages on the property and the court found the value of the

property to be $895,000.

14 While in Bonner Mall the mortgagee has an unsecured

claim, the decision renders that claim of little value because it

does not afford it absolute priority. Thus the result under Bonner

Mall is similar to Pine Gate.

1S See, e.g., Testimony of John J. Creedon on behalf of the

American Council of Life Insurance, Hearings on S.2266 and

H.R. 8200 Before the Subcommittee on Improvements in the

Judicial Machinery, Senate Committee on the Judiciary, 95th

Cong., Ist Sess. 853, 855-56 and 864-67 (1977).

1978 designed to protect the undersecured creditor by

overcoming the Pine Gate rule. This package of protection

included §§506(a), 1111(b) and 1129(b)(2). Together they

insure that (i) the mortgagee may have a secured claim

for the value of the collateral and an unsecured claim for

the difference between the value and the amount of the

indebtedness, and (ii) absolute priority for each of these

claims. '!¢

By effectively reading absolute priority for the

unsecured claim out of §1129, the Ninth Circuit’s decision

undermines this Congressional package of mortgagee

protection. The knot of protection for the mortgagee is

tied with the absolute priority requirement for the

unsecured claim. Under §1129(b)(2)(B), the dissenting

impaired unsecured class must receive property of a

value equal to the allowed amount of its claims before

any junior interest receives any property.

Of course, there may not be property available to pay

the unsecured claim in full. However, the debtor will not

be able to retain its interest in the property unless such

mortgagee in the following manner:

Section 1111(b) provides that a non-recourse claim will be con-

verted to a recourse claim for the purpose of plan confirmation

(unless a fully secured claim is elected under §1111(b)(2), not

germane here) thus assuring that the non-recourse mortgagee

will have a claim for the unsecured portion of the debt as

determined under §506(a). Section 1129(b)(1) requires absolute

priority for every class that is impaired and has not accepted the

plan. Thus, whether a mortgage is recourse, or has been con-

verted to a recourse claim, the mortgagee has absolute priority

for both the secured and unsecured claim (assuming the

unsecured class rejects the plan by the requisite majority).

debts are so paid. If the debtor in Bonner Mall is permit-

ted to keep the property without fully paying unsecured

claims, the foundation of mortgagee protection will have

been removed from the Bankruptcy Code, and the mort-

gagee will have been relegated to a situation.even more

harmful than under Pine Gate. This result would imper-

missibly expand the “new value exception” and contra-

vene both the intention of Congress and the express

language of the Bankruptcy Code.'”

V. If the Ninth Circuit’s Decision is Allowed to Stand,

It Would Have a Severe and Negative Impact on

Borrowers, Lenders and the Real Estate Industry.

If not reversed, the decision below will have a severe

adverse impact on the real estate industry. Literally bil-

lions of dollars of insurance policyholders, bank deposi-

tors, pensioners, trusts and mortgagees have been loaned

to borrowers on the strength of real property collateral

and the protection built into the Bankruptcy Code. These

Bankruptcy Code provisions were written to protect

lenders whose rights were seriously jeopardized by the

Pine Gate rule and to mandate priorities not in the former

Bankruptcy Act.

The decision below can only result in tighter credit

standards and higher interest rates for borrowers. It not

only threatens existing mortgage debt held by lenders,

17 See Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 205

(1988), where this Court stated: “Even if Congress meant to

retain the Los Angeles Lumber exception . . . it is clear that

Congress had no intention to expand that exception any fur-

ther.”

but also threatens the future of’the real estate industry,

which relies so heavily on mortgage financing.

The Bankruptcy Code was carefully drafted by Con-

gress to balance the interests of debtors and creditors and

provide for the efficient administration of bankruptcy in

the United States. If Courts are permitted by judicial

legislation to undermine the foundations of the protec-

tion afforded to real estate mortgagees, the real estate

industry and with it the national economy, will be

severely and adversely affected.

CONCLUSION

For all of the reasons set forth herein, the American

College of Real Estate Lawyers respectfully urges this

Court to reverse the decision of the Ninth Circuit below.

Respectfully submitted,

CueristorHer FP. GraHam Proressor Rosert M. ZiNMAN

THacner Prorerrtr & Woop St. John’s University

Two World Trade Center School of Law

New York, New York 10048 8000 Utopia Parkway

(212) 912-7400 Jamaica, New York 11439

(718) 990-6646

Attorneys for American

Counsel of Real Estate

Lawyers

App. 1

EXHIBIT A

STOEL RIVES BOLEY

JONES & GREY

Attorney at Law

16th Floor

One Union Square

600 University Street

Seattle Washington 98101-3197

Telephone (206) 624-0900

Telefax (206) 386-7500 MCI Mall No. 495-5830

Complaint No. 624-7580 TDD (206) 628-6206

(206) 386-7634

February 18, 1994

VIA FACSIMILE

Chris Graham, Esq.

Thacher Proffitt & Wood

Two World Trade Center

New York, N.Y. 10048

Re: In re Bonner Mall Partnership —- Supreme Court

#93-714

Dear Mr. Graham:

Pursuant to Rule 37.3 of the Rules of the Supreme

Court, we hereby grant consent to you to appear as amici

curiae in the above-referenced case.

Very truly yours,

/s/ Bradford Anderson

Bradford Anderson

A significant disadvantage to obtaining equity cush-

ion capital from either creditors or outside investors is

that these approaches offer no benefit to the existing

owners of the insolvent company, who lose control in the

reorganized company. In many cases, the existing owners

may be familiar with the business operations and have

been involved in managing the company; thus, the reor-

ganized company may be disadvantaged by the loss of

their association with it.

A more serious problem with these approaches is

that they offer the owners no reason to initiate the reor-

ganization process. If the company’s owners have no

incentive to file a reorganization proceeding, they will be

inclined to seek delay and to take increasingly risky

gambles hoping that solvency will be restored eventually

through some miracle. This is likely to lead to further

financial deterioration, to the point where recovery is no

longer possible. In theory, the insolvent company’s credi-

tors can file involuntary Chapter 11 proceedings if the

owners fail to do so. But in practice, creditors do not have

ready access to the company’s financial information, and

initiating an involuntary proceeding is difficult and risky

for them. See Douglas G. Baird, The Initiation Problem in

Bankruptcy, 11 Int’l Rev. L. & Econ. 223 (1991).

An additional justification for allowing participation

by the former owners in the reorganized company is that

they may be the best source of new capital. See Northern

Pacific Railway v. Boyd, 228 U.S. 482, 495 (1913). Unless the

owners are allowed to provide new capital for the reor-

ganizing company, the reorganization may fail and the

creditors could wind up receiving less in liquidation than

they would have under the plan. If the absolute priority

rule bars contributions of new capital from an insolvent

company’s owners, it could be detrimental to the inter-

ests of the very unsecured creditors it was designed to

protect.

Contributions of new capital from an insolvent com-

pany’s former owners should be encouraged, rather than

barred. Accordingly, this Court should recognize the new

capital exception to the absolute priority rule. At the

same time, the Court should require the form and amount

of the capital contributions to be sufficient to fulfill the

purpose of the Chapter 11 reorganization process by

restoring financial health to the reorganized company.

III. The Form of ‘se Capital Contribution

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

(1988), this Court addressed the form required for a capi-

tal contribution if the new capital exception were to be

recognized. Following Case v. Los Angeles Lumber Co., 308

U.S. 106, 121-22 (1939), the Court held that capital contri-

butions would have to be in the form of “money or

money's worth.”

The reorganization plan in Los Angeles Lumber called

for contributions from the reorganizing corporation’s for-

mer shareholders that consisted merely of their “financial

standing and influence in the community” and their pro-

viding “continuity of management.” Id. at 122. The Court

held that these intangibles were not adequate consider-

ation for the issuance of stock in the reorganized corpora-

tion, saying: “On the facts of this case they cannot

possibly be translated into money’s worth reasonably

equivalent to the participation accorded the old stock-

holders. They have no place in the asset column of the

balance sheet of the new company. They reflect merely

vague hopes or possibilities.” Id. at 122-23 (footnote omit-

ted).

The reorganization plan in Ahlers called for “yearly

contributions of labor, experience, and expertise,” 485

U.S. at 201, from the owners of a farm. As in Los Angeles

Lumber, the Court decided that these contributions of

future services were not sufficient to justify an exception

from the absolute priority rule. It reasoned:

Viewed from the time of approval of the plan,

respondents’ promise of future services is intan-

gible, inalienable, and in all likelihood, unen-

forceable. It “has no place in the asset column of

the balance sheet of the new [entity].” Los

Angeles Lumber, 308 U.S., at 122-23. Unlike

“money or money’s worth,” a promise of future

services cannot be exchanged in any market for

something of value to the creditors today. In fact,

no decision of this Court or any Court of

Appeals, other than the decision below, has ever

found a promise to contribute future labor, man-

agement, or expertise sufficient to qualify for

the Los Angeles Lumber exception to the absolute

priority rule.

Id. at 204 (emphasis in original) (footnote omitted).

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

F.2d 1351, 1362-63 (7th Cir. 1990), the Seventh Circuit

confronted a type of capital contribution similar to one

offered in the reorganization plan in this case: a share-

holder guarantee of a loan to the reorganizing corpora-

tion. The plan of reorganization provided for the

corporation’s former shareholders to retain ownership of

the corporation in return for their guaranteeing new

loans that would finance the reorganization. Id. at 1354.

Relying on Ahlers and Los Angeles Lumber, the Sev-

enth Circuit ruled that the guarantees could not consti-

tute new value for purposes of satisfying a new capital

exception to the absolute priority rule. Judge East-

erbrook’s opinion for the court pointed out that guaran-

tees are not balance-sheet assets; instead, guarantees are

intangible, inalienable, and unenforceable, because there

is no way for a corporation to prevent shareholders from

revoking their guarantees or rendering them valueless by

disposing of their assets. The court also noted that per-

sons organizing a new corporation in Illinois could not

issue stock to themselves in return for guarantees of

loans, because Illinois law restricts the consideration for

new shares to money, property, or past services. Id. at

1362. ,

The Seventh Circuit made a useful comparison in the

Kham & Nate's Shoes decision between on the one hand,

the problem of the form of new capital contributions in

the corporate reorganization context, and on the other,

the problem of “watered stock” and the form of capital

contributions required as consideration for the issuance

of stock under general corporate law. For many decades,

the trend in corporate law has been in the direction of

increasing liberalization of the form of allowed capital

contributions. 1 Model Business Corp. Act Ann. § 6.21

history (3d ed. 1989); 1 Model Business Corp. Act Ann.

§ 19 comment (2d ed. 1971). The Model Business Corpora-

tion Act (2d ed. 1971) provided:

The consideration for the issuance of shares

may be paid, in whole or in part, in money, in

other property, tangible or intangible, or in labor

or services performed for the corporation. .. .

Neither promissory notes nor future ser-

vices shall constitute payment or part payment

for the issuance of shares of a corporation.

1 Model Business Corp. Act Ann. § 19 (2d ed. 1971).

The Revised Model Business Corporation Act (3d ed.

1989) broadens the allowable consideration to “any tang:

ible or intangible property or benefit to the corporation,

including cash, promissory notes, services performed,

contracts for services to be performed, or other securities

of the corporation.” 1 Model Business Corp. Act Ann.

§ 6.21 (3d ed. 1989). The Official Comment to Section 6.21

explains:

Section 6.21(b) specifically validates con-

tracts for future services (including promoters’

services), promissory notes, or “any tangible or

intangible property or benefit to the corpora-

tion,” as consideration for the present issue of

shares. . . . In the realities of commercial life,

there is sometimes a need for the issuance of

shares for contract rights or such intangible

property or benefits. And, as a matter of busi-

ness economics, contracts for future services,

promissory notes, and intangible property or

benefits often have value that is as real as the

value of tangible property or past services, the

only types of property that many older statutes

permit as consideration for shares.

ee eee

Whether intangible property should be a permissible

form for a new capital contribution in a bankruptcy reor-

ganization should depend on the applicable state corpo-

rate law. See Butner v. United States, 440 US. 48, 55 (1979)

(in the absence of an overriding federal interest, property

rights in bankruptcy proceedings should be determined

by reference to state law). Thus, if the applicable state law

would permit a promise of future services (as in Ahlers)

or a shareholder guarantee (as in Kham & Nate's Shoes or

this case) to constitute allowable consideration for the

issuance of stock in a corporation, then these forms of

intangible property should be permissible as capital con-

tributions, whether they come from a former shareholder

or an outside investor. Most states (including Idaho),

however, continue to follow Section 19 of the Model

Business Corporation Act (2d ed. 1971) and prohibit the

issuance of shares in exchange for such forms of intang-

ible property. See 1 Model Business Corp. Act Ann. § 6.21

annot. at 370-71 (3d ed. 1989) (listing states).

IV. The Amount of the Capital Contribution

The prevailing standard for the amount of the new

capital contribution in a plan of reorganization comes

from the following dictum in Case v. Los Angeles Lumber

Co., 308 U.S. 106, 122 (1939): “(T]he stockholder’s Partici-

pation must be based on a contribution in money or in

money’s worth, reasonably equivalent in view of all the

circumstances to the participation of the stockholder.”

Because the shareholders’ contribution in that case was

not “in money or in money’s worth,” it was not in the

proper form, and the Court did not decide whether it was

“reasonably equivalent” to the value of the equity the

shareholders were to receive under the plan. Thus, the

Court’s statement concerning the amount of the new

capital contribution was not part of the holding.

Although this standard appears reasonable, it pro-

vides no real guidance to courts, because it is a tautology.

See Bruce A. Markell, Owners, Auctions, and Absolute Prior-

ity in Bankruptcy Reorganizations, 44 Stan. L. Rev. 69,

96-101 (1991). Under the absolute priority rule, all of an

insolvent company’s value must be allocated to its credi-

tors; any debt in excess of its value as a going concern is

discharged. When new capital is contributed, the Los

Angeles Lumber dictum will be satisfied as a matter of

course, because the only value not allocated to the credi-

tors is the new capital contribution. As Professor Markell

notes, rather than placing any limits on the new capital

exception to the absolute priority rule, the Los Angeles

Lumber standard “merely rephrases the . . . rule.” Id. at

101.

In order to repair an insolvent company’s capital

structure in the course of the reorganization process, its

liabilities must first be written down to the going concern

value of the assets. At that point, the going concern value

of the company’s assets net of its liabilities is zero. The

going concern value of the company’s assets net of lia-

bilities may not be greater than zero, because if it were,

the creditors would be entitled to the excess as a result of

the absolute priority rule. A contribution of new capital

to the reorganizing company causes its going concern

value net of its liabilities to increase precisely by the

amount of the contribution. Since the contribution will

always be equivalent to the resulting going concern value

net of liabilities, the amount of the capital contribution

that is required in the reorganization process cannot be

determined from the company’s going concern value.

The indeterminacy of the Los Angeles Lumber stan-

dard may be demonstrated with a numerical example.

Consider the balance sheet of a company that initially has

assets with a going concern value of $1 million and

liabilities of $3 million. Writing down the liabilities to $1

million (the going concern value of the assets) would

yield a net going concern value of zero. If an owner or

other investor were to make a capital contribution of as

little as $5,000 after the writing down of the liabilities, the

going concern value of the company’s assets after the

contribution would be $1,005,000 and its net going con-

cern value would be $5,000. This is illustrated below.

Before Reorganization

Assets $1,000,000 Liabilities $3,000,000

Equity -2,000,000

Total $1,000,000 $1,000,000

After Reorganization

Assets $1,000,000 Liabilities $1,000,000

Shareholder

Contribution 5,000 Equity 5,000

Total $1,005,000 $1,005,000

An owner’s contribution of new capital does not

vanish when it is made; instead, it increases the going

concern value of the reorganized company. The increase

in going concern value resulting from the infusion of new

capital may be even larger than the amount of the new

capital contribution, and over time, the participation of

former owners may contribute to the company’s going

concern value, particularly if they are involved in the

company’s management or operations.

Since the Los Angeles Lumber standard is fundamen-

tally unsound, it should be replaced with a better stan-

dard that is consistent with the purpose of the Chapter 11

reorganization process. The most appropriate criterion

for the size of the new capital contribution is that it

should be sufficient to provide an adequate equity cush-

ion. The price that the new owners of a reorganized

business should be required to pay for control following

the reorganization is neither the going concern value

(which will initially be zero if the company’s assets are

valued correctly and the absolute priority rule is applied)

nor the amount of liabilities that are to be discharged.

Instead, the price should be that the new owners must

put up a sufficient stake in the enterprise to absorb any

future losses that can reasonably be anticipated, thus

reducing the risks to the creditors.

Absolute protection for a company’s creditors is not

attainable. No business is entirely risk free, and there is

always some possibility of future losses to creditors that

cannot be eliminated with any finite amount of equity

capital. Although creditors cannot expect to receive abso-

lute protection, they can be shielded from most risk of

loss through the maintenance of an adequate cushion of

equity. An adequate cushion of equity means the com-

pany’s owners will have appropriate incentives to maxi-

mize the long term value of the company, whether the

equity cushion comes from outside investors or from

former owners. The equity cushion ought to be large

enough, not only to keep the potential conflicts of interest

between owners and creditors to a minimum, but also to

absorb any fluctuations in earnings that can reasonably

be anticipated. Otherwise, there is too great a risk of

another insolvency, and the reorganization will have been

for naught.

To protect the company’s existing and future credi-

tors from a second insolvency, the “feasibility require-

ment” in section 1129(a)(11) of the Bankruptcy Code

provides that a bankruptcy court should confirm a reor-

ganization plan only if confirmation “is not likely to be

followed by the liquidation, or the need for further finan-

cial reorganization, of the debtor.” This requirement has

long been a part of the law of bankruptcy reorganiza-

tions. To determine whether a plan satisfies the feasibility

requirement, the courts normally look at whether there is

a reasonable prospect for the reorganization plan to be

successful. While the adequacy of a debtor’s capital struc-

ture is often listed as one of the factors used in analyzing

a plan’s feasibility, the bankruptcy courts have tended to

concentrate more on the accuracy of the plan’s income

projections than on the need for the owners of the reor-

ganized company to have a significant stake in the enter-

prise.

The feasibility requirement cannot be satisfied if the

reorganized business is so thinly capitalized that it is

unable to withstand some future losses. The largest possi-

ble equity cushion would be provided by an all-equity

capital structure, but most companies operate satisfac-

torily with substantial levels of debt. The presence of debt

increases risk, but the reorganized company obtains off-

setting benefits from the tax advantages and leverage that

debt financing provides. And subject always to the stabil-

ity of the expected earnings for the reorganized company,

the risk of insolvency following reorganization can be

held to an acceptable level by maintaining an adequate

equity cushion.

A variety of factors may potentially influence a com-

pany’s capital structure. These include the company’s

profitability, the uniqueness of its products, the degree of

specialization of its equipment and its employees, and the

extent of equity ownership by its management. See Milton

Harris & Artur Raviv, The Theory of Capital Structure, 46 J.

Fin. 297, 337-40 (1991) (summarizing theoretical and

empirical studies on the effect of these and other factors

on a corporation's capital structure). However, the pri-

mary factor affecting a company’s capital structure is

generally the volatility of its earnings. A number of

studies have shown, for example, that corporations in

regulated industries, which tend to have stable earnings,

have the highest proportions of debt, while pharmaceuti-

cal and electronics manufacturers, which tend to have

volatile earnings, have the smallest proportions of debt.

Id. at 333-35. Therefore, the capital structures of other

companies in the same industry may provide a gauge for

a bankruptcy court to use in evaluating the adequacy of a

proposed equity cushion in a reorganization plan. Cf.

Lynn M. LoPucki & William C. Whitford, Patterns in the

Bankruptcy Reorganization of Large, Publicly Held Com-

panies, 78 Cornell L. Rev. 597, 607-09 (1993) (companies

emerging from reorganizations tend to have higher debt-

to-equity ratios than companies of comparable size in the

same businesses).

Although there may not be any precise formula for

determining an ideal capital structure for a reorganized

company, in many cases a bankruptcy court can be rea-

sonably certain that a capital structure proposed in a plan

under review is inadequate. For example, it is clear that a

business should not be allowed to emerge from the reor-

ganization process without any equity cushion. For closer

cases, the bankruptcy court may need expert testimony

from a financial analyst concerning the adequacy of cap-

italization and possibly also from a lender as to the

likelihood of the debtor being able to borrow the debt

provided for in the plan from an informed outside source.

See In re Mobile Steel Co., 563 F.2d 692, 703 (Sth Cir. 1977)

(listing methods for determining the adequacy of capital-

ization in equitable subordination cases).

The adequacy of the capital contribution proposed in

this case is addressed below.

Vv. Application to the Facts of This Case

In this case the debtor’s primary asset is a shopping

mall in Idaho, which the bankruptcy court valued at $3.2

million. Its major liability is a loan of $6.6 million secured

by a deed of trust against the mall. The debtor’s plan

provides for repayment of the secured portion of the loan

($3.2 million) 32 months after confirmation with interest

payable monthly in the interim. Unsecured creditors with

claims greater than $1,000 will receive a pro rata distribu-

tion of 300,000 shares of preferred stock, which has a par

value of $1.00 per share and is convertible to a maximum

of 300,000 shares of common stock upon repayment of the

secured portion of the loan. The preferred shares will

have a liquidation preference over the common stock. The

debtor’s six former partners together are to contribute

cash of $200,000 and will receive 2 million shares of

common stock in return. In addition, the plan calls for the

partners to subsidize any shortfall in working capital

during the first 32 months after confirmation of the plan

and for five of the former partners to contribute a collat-

eral trust mortgage on other property as a guarantee of

the debts that are being assumed by the reorganized

business. See In re Bonner Mall Partnership, 2 F.3d 899, 905

(9th Cir. 1993).

It is apparent that the reorganized corporation would

be too thinly capitalized to satisfy the feasibility require-

ment. Even though the reorganized corporation would

not be immediately insolvent if the plen were confirmed,

the common shareholder's equity ‘#iterest would be

“under water” on account of the issuance of the 300,000

shares of $1.00 par value preferred stock to the corpora-

tion’s former unsecured creditors. The issuance of the

preferred shares would therefore violate the stated capital

requirements of applicable Idaho law. See Idaho Code

§§ 30-1-18, 30-1-21 (1980) (prohibiting the issuance of

shares for less than their par value). With only a $200,000

equity cushion, the common shareholders would not be

entitled to any profits until the $100,000 impairment of

capital resulting from issuance of the preferred stock was

cured. Consequently there is a potential conflict of inter-

est between the common and preferred shareholders built

into the capital structure of the reorganized corporation.

The Bonner Mall plan is also deficient on account of

the size of the equity cushion. There are a number of

factors that affect the size of a real estate loan, but most

lenders require at least a 75% loan to value ratio:

Since the beginning of the commercial mortgage

business, lenders have imposed a 75% loan-to-

value limit as being prudent. This real estate

recession has unfortunately shown that even

that level of leverage was too aggressive. As a

result, a number of survey members are now

requiring that their commercial mortgages meet

a 65% loan-to-value test or less.

John B. Levy, Regulations Prompt Higher Minimum Spreads,

35 Nat'l Real Estate Investor 24 (Mar. 1993). Cf. 79 Fed.

Reserve Bull. A37 (Sep. 1993) (loan-to-value ratios for

mortgages on new homes ranged from 74.8% to 79.5%

between 1990 and June, 1993). An appropriate equity

cushion for the secured creditor’s $3.2 million claim

might therefore be in the neighborhood of $1 million,

instead of the $200,000 called for in the reorganization

plan.

The plan also calls for the former partners to subsi-

dize any shortfall in working capital and to guarantee the

payment of the reorganized «rporetions with a collateral

trust mortgage. Depending on the circumstances, these

guarantees might have sufficient value to compensate for

the lack of a more substantial cash contribution. How-

ever, they would not be allowed as consideration for the

issuance of new shares under applicable Idaho law. See

Idaho Const. art. XI, § 9 (“No corporation shall issue

stocks or bonds, except for labor done, services per-

formed, or money or property actually received; and all

fictitious increase of stock shall be void.”); Idaho Code

§ 30-1-19 (“The consideration for the issuance f shares

may be paid, in whole or in part, in cash, in ower prop-

erty, tangible or intangible, or in labor or services actually

performed for the corporation.”). Thus, they should not

be considered part of the equity cushion of this reor-

ganized corporation.

Accordingly, the reorganization plan does not satisfy

the feasibility standard and should not be confirmed.

Even if this Court concludes that the record is not

sufficiently clear to decide on confirmation of the reor-

ganization plan, the Court should specify the standard

clearly enough for the lower courts to apply. The stan-

dard should be based on the capital structure of the

reorganized company having an equity cushion that is

adequate to withstand reasonably foreseeable variations

in future earnings. The adequacy of the equity cushion

may be determined by comparison to the capital struc-

tures of similar businesses and from testimony of finan-

cial experts.

CONCLUSION

Inseparable from the issue of whether a new capital

exception to the absolute priority rule should exist is the

question of what its parameters should be. In addition to

recognizing this exception, this Court should enunciate

reasonable standards for the form and amount of the new

capital required for confirmation of a reorganization plan.

Respectfully submitted,

CHarctes W. ADAms

Professor of Law

The University of Tulsa College

of Law

3120 East Fourth Place

Tulsa, OK 74104

(918) 631-2437

Amicus Curiae

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