Amicus Curiae Brief — Bank of America Nat. Trust and Sav. Assn. v. 203 North LaSalle Street Partnership

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FILE Dp

No. 97-1418

Supreme Court of the United States

October Term, 1997

+

BANK OF AMERICA NATIONAL TRUST

AND SAVINGS ASSOCIATION,

Successor by Merger to Bank of America Illinois,

Petitioner,

203 NORTH LASALLE STREET PARTNERSHIP.

Respondent

+

On Writ Of Certiorari

To The United States Court Of Appeals

For The Seventh Circuit

+

BRIEF OF THE AMERICAN COLLEGE OF REAL

ESTATE LAWYERS AS AMICUS CURIAE IN

SUPPORT OF PETITIONER

+

Of Counsel: Counsel of Record:

Cart J. Senexer, Il Pror. Rosert M. ZiInMaAn

President, American St. John’s University

College of Real School of Law

Estate Lawyers 8000 Utopia Parkway

Jamaica, New York 11439

THomas C. HomsBurGer (718) 990-6646

Co-Chair, Amicus Briefs

Committee, American

College of Real

Estate Lawyers

CHRISTOPHER F. GRAHAM

THACHER, Prorrittr & Woop

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

OR CALL COLLECT (402) 42-2831

ae ee

QUESTIONS 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.

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

value exception” as articulated by this Court in dicta in

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

(1939), whether the Seventh Circuit properly applied the

exception.

**

TABLE OF CONTENTS

Page

QUESTIONS PRESENTED . ....cccsssdiuntteeeee i

TABLE OF AUTHORITERS .. .6sssccntseccssnessa iv

STATEMENT OF INTEREST OF AMICUS CURIAE... 1

SUMMARY OF ARGUMENT soscnedsideenieneneneen 2

ARGUMENT ......cccccucscettavenewenee 3

I. THE SO-CALLED NEW VALUE EXCEPTION

OR NEW VALUE COROLLARY DID NOT SUR-

VIVE THE ADOPTION OF THE BANKRUPTCY

a8) MPrTerrrr rrr yee 3

A. Confirmation of New Value Plans Prior to

the Adoption of the Bankruptcy Code is an

PeesiOR. . «..2ccccdseds beech ee 4

B. Congress Rejected the New Value Exception

When it drafted the Bankruptcy Code..... 5

C. The Language of the Bankruptcy Code Pre-

cludes the Confirmation of New Value

Il. THE NEW VALUE EXCEPTION AS ADOPTED

BY THE SEVENTH CIRCUIT DISTORTS THE

NEW VALUE COROLLARY AS ARTICULATED

IN DICTA BY THIS COURT AND-MOLDS IT

INTO AN EXCEPTION THAT WOULD EFFEC-

TIVELY ABROGATE THE ABSOLUTE PRIOR-

ITY REQUIREMENTS OF THE BANKRUPTCY

CUE 2. ccc ccccccete sense aan nine 10

TABLE OF CONTENTS - Continued

Page

A. The Seventh Circuit Ignores the Creditor

Protection Prong of this Court's Articula-

tion of the New Value Requirements......

B. The Seventh Circuit Distorts the Other Pre-

requisites to New Value Articulated by this

eI a

1. The Seventh Circuit distorts the require-

ment that the contribution be essential

to the success of the undertaking......

2. Reasonable equivalence is eliminated in

MOrGGy GHUATONS .... 2... cece cesses

3. The new requirement of substantiality

serves as a smoke screen for the failure

to follow the Case prerequisites........

Ill. THE APPLICATION OF THE SEVENTH CIR-

CUIT’S VERSION OF NEW VALUE TO SINGLE

ASSET REAL ESTATE REORGANIZATIONS

WOULD SERVE NO PUBLIC PURPOSE, ABRO-

GATE THE PROTECTION FOR MORTGAGEES

BUILT INTO THE BANKRUPTCY CODE, AND

HAVE A SEVERE NEGATIVE IMPACT ON

BORROWERS, LENDERS AND THE REAL

EE csi es coccccedcvecesccccces

TE OID os veces kessccccccsece

B. Abrogation of Mortgagee Protection.......

C. Negative Impact on the Real Estate Industry

PREPSCSSSSSSseeseeeeseseeeesneeseeseeseseeeseeesesces

1]

14

14

15

17

iv

TABLE OF AUTHORITIES

Page

Cases

Case v. Los Angeles Lumber Products Co., 308 U.S.

ee Ga bbc cad otdxeectecdetebaseewunh Gibes passim

Coltex Loop Central Three Partners, L.P. v. BT/SAP Pool

C Associates, L.P. (In re Coltrex Loop Central Three

Partners, L.P.), 138 F.3d 39 (2nd Cir. 1998).......... 3, 9

Dewsnup v. Timm, 502 U.S. 410 (1992) ............0... 7

In re 203 N. LaSalle Street Partnership, 126 F.3d 955

res Ga Hr css ca se caddis odes edcieeeeeks passim

In re 203 N. LaSalle Street Partnership, 190 B.R. 567

GD, Pee Be. COUN ochevdncscvacs ixbies 8, 9, 16, 17

In re DRW Property Co. 82, 57 B.R. 987 (Bankr. N.D.

Wate. MD a ac'dishecnesecaddbs Medes seine 22

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

(CRR) 1478 (Bankr. N.D. Ga. 1976)......... 21, 22, 23

In re Snyder, 967 F.2d 1126 (7th Cir. 1992)........... 17

In re Woodbrook Associates, 19 F.3d 312 (7th Cir.

POOR 61 ne oscacdkdtasdankiies Veinsaneteokuiea 17, 18

Kansas City Terminal Railway Co. v. Central Union

Trust Co., 271 U.S. 445 (1926) .............. 11, 12, 14

Louisville Trust Co. v. Louisville, N.A. & C. Railroad

Cg SPD Wreee Ge C aiawi cos kv cowevnesSeen nuns 12

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

GUM 66000 t0ndevastduacs wiatedsnabestcadadnks 12, 16

Vv

TABLE OF AUTHORITIES - Continued

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

GUNN 64h Ahan ch ubedieudeniekidekauidwaebbcaketec. 16

State Mutual Assurance Co. of America v. KRO Asso-

ciates (In re KRO Associates), 4 Bankr. Ct. Dec.

(CRR) 462 (Bankr. S.D.N.Y. 1978).................. 21

Wright v. Union Central Life Insurance Co., 311 U.S.

SPE MES dikd tride dees hide envhdetsendlacutuah cla 8

STATUTES

Pe es MOD blu dcone sa twud dues toin gotkice cass 21

eS ae SR Aa S ie dcbaa becker dak: Gb iikcs 22, 23

Se ees Or SUED asanividacubatiawececs. 6, 8, 9, 21, 22

48 Stat. 912 (Bankruptcy Act of 1898 oo 6, 11

MISCELLANEOUS

John D. Ayer, Rethinking Absolute Priority After

Ahlers, 87 Mich. L. Rev. 963 (1989).............. 4, 13

Walter J. Blum & Stanley A. Kaplan, The Absolute

Priority Doctrine in Corporate Reorganizations, 41

he Ce Bay BM GS QISUUD oc evo occcdecuccccccecces 5

Victor Brudney, The Bankruptcy Commission's Pro-

posed “Modifications” of the Absolute Priority Rule,

48 Am. Bankr. L.J. 305 (1974)...................... 5

Bruce A. Markell, Owners, Auctions, and Absolute

Priority in Bankruptcy Reorganizations, 44 Stan. L.

Sey et SUE chohndk isis bs das esd wk cane cuca sere 4, 13

Note, The Proposed Bankruptcy Act: Changes in the

Absolute Priority Rule for Corporate Reorganiza-

tions, 87 Harv. L. Rev. 1786 (1974) ................. 5

vi

TABLE OF AUTHORITIES —- Continued

Robert M. Zinman, New Value and the Commission:

How Bizarre!, 5 Am. Bankr. Inst. L. Rev. 477

GTR cc cccccccdeuepsiscstndbapetesbscuahsssesvacs

Hearings on S. 2266 and H.R. 8200 Before Subcomm.

on Improvements on the Judicial Machinery of the

Senate Comm. on the Judiciary, 95th Cong. (1977)

(statement of John J. Creedon, American Coun-

cil of Life Insurance) .........cccencecceccerececns

5 Cour oN Bankruptcy J 506.03[4][e], at n.58

(Lawrence P. King et al. eds. 15th ed. rev. 1997) ....

Report of the Commission on the Bankruptcy

Laws of the United States, H.R. Doc. No. 93-137

CGE nv ccvinedvopevescsccocsvccevsscusesceyicdres

S. Rep. No. 598 (1978), reprinted in 1978

CEOS EO 8 SD icdcnwetdvudedosdsdntendsrendeeks

Page

BRIEF AMICUS CURIAE FOR AMERICAN COLLEGE

OF REAL ESTATE LAWYERS IN SUPPORT

OF THE PETITIONER

This brief is filed on behalf of the American College

of Real Estate Lawyers as amicus curiae, in support of the

Petitioner. !

,

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,

! Counsel for a party did not author this brief in whole or in

part. No person or entity, other than the Amicus Curiae, its

members, or its counsel made a monetary contribution to the

preparation and submission of this brief.

2 Consent letters have been obtained from counsel for the

parties, copies of which accompany this brief.

lenders, investors and developers. The case at bar

involves a debtor whose single asset is an interest in

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. Whether the

property securing the debt may be retained by the

debtor’s partners under a new value plan without paying

the debt is an issue of significant concern to the real

estate industry.

This brief supports the brief of the Petitioner in this

case. Due to the background of the Amicus, its experience

as counsel to lenders and borrowers, and its familiarity

with the confusion, costs and consequences to the real

estate industry arising from the ambiguities created by

the issues before this Court, ACREL is in a unique posi-

tion to offer its expertise concerning the adverse conse-

quences of an affirmance of the decision below on the

availability of financing for the acquisition, development,

and financing of commercial real property in the United

States.

SUMMARY OF ARGUMENT

This brief urges that the Seventh Circuit be reversed

for the following reasons:

1. There is no new value exception or corollary to

the fair and equitable requirement of the Bankruptcy

Code. The new value principle as articulated in dicta

prior to the adoption of the Bankruptcy Code was

rejected by Congress in favor of a more flexible and

modified absolute priority rule that obviated the need for

a new value principle.

2. The new value exception applied by the Seventh

Circuit distorts the new value corollary articulated by this

Court in its Case v. Los Angeles Lumber and represents a

post-Code invention that contravenes the parameters set

by Justice Douglas in Case and threatens the very exis-

tence of the absolute pricrity rule.

3. The Seventh Circuit’s decision undermines the

protection for real estate mortgages built into the Bank-

ruptcy Code and threatens to have a severe negative

impact on the real estate industry and the availability of

real estate mortgage financing.

°

ARGUMENT

I. THE SO-CALLED } “-W VALUE EXCEPTION OR

NEW VALUE COROLLARY DID NOT SURVIVE

THE ADOPTION OF THE BANKRUPTCY CODE.

This brief supports the conclusions and reasoning of

the brief of the Petitioner, the dissent of Judge Kanne in

the Seventh Circuit’s opinion in In re 203 N. LaSalle Street

Partnership, 126 F.3d 955, 970 (7th Cir. 1997), and the

opinion of the Second Circuit in Coltex Loop Central Three

Partners, L.P., v. BT/SAP Pool C Associates, L.P. (In re Coltex

Loop Central Three Partners, L.P.), 138 F.3d 39 (2d Cir.

1998), that there is no holdover new value exception or

corollary to the absolute priority rule of the Bankruptcy

Code.

A. Confirmation of New Value Plans Prior to the

Adoptio:r of the Bankruptcy Code is an Illu-

sion.

The Seventh Circuit stated that “the new value corol-

lary has long been ensconced in our bankruptcy prac-

tice,” 126 F.3d at 965, and that it has been “a major source

of new funding in reorganizations for the past fifty

years.” Id. at 966. From this predicate, the Seventh Circuit

concluded that “one would expect that Congress would

address deliberately such a significant issue of economic

policy if it had determined to abolish it.” Id. The problem

with this conclusion is that its predicate is incorrect.

From the decision of this Court in Case v. Los Angeles

Lumber Products Co., 308 U.S. 106 (1939), to the adoption

of the Bankruptcy Code in 1978, there appears to be no

published evidence that any “shareholder was ever able

to convince a court that she contributed sufficient value

to be able to retain an interest. Indeed, until the Code’s

adoption in 1978, no reported case seems to have adopted

Justice Douglas’ dicta as its holding.” Bruce A. Markell,

Owners, Auctions, and Absolute Priority in Bankruptcy Reor-

ganizations, 44 Stan. L. Rev. 69, 92 (1991). See also John D.

Ayer, Rethinking Absolute Priority After Ahlers, 87 Mich. L.

Rev. 963, 1016 (1989), where Professor Ayer concludes,

“Justice Douglas’ supposed ‘exception,’ . . . is nowhere

present as a rule of decision in Chapter X cases. New

value under Chapter X, then, is an illusion.”

Thus, there was no 50 year history of the new value

exception being part of bankruptcy “practice.” While the

new value theory, as expressed in dicta by this Court in

Case, was known, the purported employment of that the-

ory never became part of bankruptcy “practice” until after

the adoption of the Bankruptcy Code.

B. Congress Rejected the New Value Exception

When It Drafted the Bankruptcy Code.

In 1973, the Commission on the Bankruptcy Laws of

the United States in its Report, concluded that under the

absolute priority rule, debt and equity security holders

are ‘frequently eliminated from participation in a reor-

ganization by reason of the strict application of a statute

designed primarily for their protection.” H.R. Doc. No.

93-137, pt. 1, at 256 (1973). The absolute priority rule did

not permit old equity to participate even with the agree-

ment of all classes of creditors. The Commission’s solu-

tion was to modify the absolute priority rule by

permitting juniors to participate on the basis of a contri-

bution “important to the operation of the reorganized

debtor . . . under the plan” on a basis reasonably approx-

imating the value of their contribution. H.R. Doc. No.

93-137, pt. 2, at 242. This proposal created a storm of

criticism, see, e.g., Victor Brudney, The Bankruptcy Commis-

sion’s Proposed “Modifications” of the Absolute Priority Rule,

48 Am. Bankr. L.J. 305, 337 (1974); Walter J. Blum &

Stanley A. Kaplan, The Absolute Priority Doctrine in Corpo-

rate Reorganizations, 41 U. Chi. L. Rev. 651, 669-70 (1974);

Note, The Proposed Bankruptcy Act: Changes in the Absolute

Priority Rule for Corporate Reorganizations, 87 Harv. L. Rev.

1786, 1817 (1974), and was rejected by Congress.

In its place, Congress modified the absolute priority

rule to limit its application to dissenting impaired classes

of creditors only,* thus freeing classes of creditors to

admit junior interests by agreement. If this limited abso-

lute priority had been in effect under the Bankruptcy Act,

the Case plan would have been confirmed* and the issue

that produced the new value dicta would never have

arisen. Thus the Bankruptcy Code obviated the need for a

new value corollary. Recognizing such a modification of

the absolute priority rule, the dissent in LaSalle noted,

“the pre-Code rationale for the new value exception

makes little sense in today’s Chapter 11 environment.”

126 F.3d at 976. Congress considered a provision that

would have incorporated new value into the Code (even

including, it would seem, alternative forms of contribu-

tion, such as were proffered in Case), rejected it, and

* Under the Bankruptcy Act, “Congress ha[d] required both

that the required percentages of each class of security holders

approve the plan and that the plan be found to be ‘fair and

equitable’. The former [was] not a substitute for the

latter. . . . Accordingly the fact that the vast majority of the

security holders ha[d] approved [a] plan [was] not the test of

whether the plan [was] a fair and equitable one.” Case, 308 U.S.

at 114 (interpreting § 77B of the Bankruptcy Act, superseded by

Chapter X). Compare Bankruptcy Code § 1129(b)(1) (applying

the fair and equitable requirement only to dissenting, impaired

classes).

+ Though the Case plan had been approved by all classes of

creditors, one individual creditor objected. The objecting

creditor held an obligation with a face amount of $18,500, as

compared to almost four million dollars in bonds outstanding.

The objecting creditor's class approved the plan, and had the

Bankruptcy Code been in effect, the plan would have been

confirmed without employing the cramdown provision of

§ 1129%(b).

enacted the compromise that allowed for participation by

agreement.

The Seventh Circuit opined that Congress incorpo-

rated the new value exception when it drafted the Bank-

ruptcy Code because, “[w]hen Congress amends the

bankruptcy laws, it does not write ‘on a clean slate.’ ” 126

F.3d at 965 (quoting Dewsnup v. Timm, 502 U.S. 410, 419

(1992)). The facts, however, indicate either that new value

was not on Congress's slate when the Bankruptcy Code

was being considered, or that Congress had erased new

value from whatever was on its slate before it began to

write.

C. The Language of the Bankruptcy Code Pre-

cludes the Confirmation of New Value Plans.

The clear language of Bankruptcy Code

§ 1129(b)(2)(B) provides that a plan is not fair and equita-

ble as to a dissenting impaired class of creditors if a

junior interest, such as old equity, retains an interest on

account of its junior interest in the debtor. Yet the Seventh

Circuit, in LaSalle, permits such a result.

The Seventh Circuit maintains that old equity's inter-

est is not being retained “on account of” its former inter-

est, but rather because the debtor’s partners have made a

bid for the enterprise, as a third party might, in the form

of new value. 126 F.3d at 964. It stretches credulity to

believe that old equity, in control of all the information

about the property and with the exclusive right to retain

5 The term “old equity” as used herein refers to the

stockholders, partners, or principals of the debtor.

an interest through a new value contribution under the

plan, is not retaining an interest “on account of” its junior

interest. Indeed, in LaSalle the Bankruptcy Court virtually

admitted the motivation for the debtor’s plan was based

on old equity’s junior interest in the partnership. It stated

that the plan was submitted for the purpose of protecting

the partners from tax losses arising out of their partner-

ship interest in the debtor. See In re 203 N. LaSalle Street

Partnership, 190 B.R. 567, 588 (Bankr. N.D. Ill. 1995) (“The

debtor’s partners thus seek to retain their interests not

because of the intrinsic value of these interests, but

because of the tax consequences that flow from their

loss.”) (emphasis added).®

Additionally, the language of the Bankruptcy Code

precludes confirmation of new value plans in another

way. Consistent with the decisions of this Court acknowl-

edging that a secured creditor's property right in the

collateral must be protected up to the value of the collat-

eral, see Wright v. Union Cent. Life Ins. Co., 311 U.S. 273,

278 (1940) (where Justice Douglas stated that the Fifth

Amendment required that safeguards “protect the rights

of secured creditors, throughout the proceedings, to the

extent of the value of the property”), Congress provided

in § 1129(b)(2)(A)(i) that the secured claim be equal in

amount and value to the value of the collateral as of the

® The Seventh Circuit did not disturb the Bankruptcy

Court's finding that the plan was being submitted on account of

the tax liabilities arising from the partners interest in the debtor.

In connection with the bank’s claim that the tax motivation

evidenced lack of good faith, the Seventh Circuit stated that

“the desire to avoid significant tax liabilities, if legal, is a result

consistent with the Bankruptcy Code.” 126 F.3d at 969.

effective date of the plan. If old equity’s new value contri-

bution constitutes a bid for the property, it is a bid in

excess of what was previously believed to be the value of

the property. Section 1129(b)(2)(A) requires that the

secured claim be equal to the value of the collateral and

thus the secured claim must be increased to the higher

value. As a result, at least in single asset situations,

unless the senior secured class votes to include a partici-

pation by old equity, or, as suggested in Coltex, the prop-

erty is auctioned off to the highest bidder, see 138 F.3d at

44-45, the language of the Bankruptcy Code would pre-

clude confirmation of a plan, such as that proposed in

LaSalle, under which the property is to be acquired by old

equity over the objection of the secured creditor for less

than the full amount of the mortgage balance.’

7 In LaSalle, the Bankruptcy Court attempted to deflect this

argument by finding that the bid was not based on the

“intrinsic” value of the real estate “but because of the tax

consequences that flow from their loss.” 190 B.R. at 588.

However the price paid for property is normally considered

determinative of value without an examination of the

motivations of the purchaser. “[I]f the collateral is actually sold

during the course of the bankruptcy proceedings or pursuant to

a confirmed plan, the consideration received from the sale will

almost always resolve the question of value.” 5 CowierR On

Bankruptcy J 506.03[4}[a] at n.58 (Lawrence P. King et al. eds.

15th ed. rev.1997). Indeed, in LaSalle, the bankruptcy court itself,

in referring to what would be paid on the deficiency claim,

stated that the creditor will receive “50% of the net value of the

property either as realized in a sale, or as appraised at the time of

any refinancing.” 190 B.R. at 576 (emphasis added). The price

paid indicates value. The motivation of the purchaser is

irrelevant. If the purchaser’s motivation for buying were a

consideration in determining value, every purchase price could

be attacked as not representing the value of the property since

10

It is thus clear from the language of the Bankruptcy

Code and the intent of Congress that under the Bank-

ruptcy Code, a plan granting an interest to old equity

cannot be imposed on a dissenting, impaired class of

creditors that has not been afforded absolute priority,

whether or not new value is contributed.

Il. THE NEW VALUE EXCEPTION AS ADOPTED BY

THE SEVENTH CIRCUIT DISTORTS THE NEW

VALUE COROLLARY AS ARTICULATED IN

DICTA BY THIS COURT AND MOLDS IT INTO

AN EXCEPTION THAT WOULD EFFECTIVELY

ABROGATE THE ABSOLUTE PRIORITY

REQUIREMENTS OF THE BANKRUPTCY CODE.

As discussed above, this brief argues that no new

value principle survived the adoption of the Bankruptcy

Code. Even if this Court should conclude that new value

is still viable, the Seventh Circuit should be reversed

because the supposed “new value corollary” applied by

the Seventh Circuit is not the corollary to absolute prior-

ity articulated by this Court in Case v. Los Angeles Lumber

Products Co., 308 U.S. 106 (1939).

each purchaser brings its own baggage to the bidding table,

whether it be the purchaser’s tax or financial situation,

architectural preferences, availability of funds for investment,

or individual preferences. Valuation based on motivation would

be an invitation to manipulation and litigation.

11

A. The Seventh Circuit Ignores the Creditor Pro-

tection Prong of this Court’s Articulation of the

New Value Requirements.

In Case, this Court struck down a plan under which

old equity attempted to circumvent the requirement that

a plan had to be “fair and equitable,” which term requires

that interests in the debtor be distributed on the basis of

“absolute priority.” 308 U.S. at 115-17. The Case plan,

approved by all classes of creditors, would have allowed

old equity to retain an interest in the debtor based on a

promised contribution of expertise even though creditors

were not fully compensated.*

This Court noted that it had previously stated that

creditors could be protected “through other arrange-

ments, which distinctly recognize their equitable right to be

preferred to stockholders against the full value of all property

belonging to the debtor . . .” 308 U.S. at 117 (quoting Kansas

City Terminal Ry. Co. v. Central Union Trust Co., 271 U.S.

445, 454 (1926)) (emphasis added). Justice Douglas stated

that where the necessity for funds exists and old equity

makes a fresh contribution “and receive[s] in return a

participation reaso»ably equivalent to their contribution,”

the creditors cannot object on the ground that they were

not accorded their “full right of priority against the cor-

porate assets.” Id. (emphasis added).

The dicta in Case permitted old equity to participate

only if certain conditions were met. Foremost among

those conditions was that the creditors’ “full right of

* Case was decided under § 77B of the Bankruptcy Act of

1898 (48 Stat. 912).

12

priority” against the debtor’s assets be preserved.’ 308

U.S. at 122. Old equity could not participate “at the

expense of the prior rights . . . of credit~z+ ” Id. at 116. It

is this creditor protection prong of the — ese dicta that the

Seventh Circuit, and cases adhering to its view, ignore. In

LaSalle, old equity was allowed to retain valuable prop-

erty at the expense of the unpaid mortgagee, which

received only 16% on its deficiency claim. This would

* This principle was articulated in many ways in the

language of the decision. For example: (i) Justice Douglas,

quoting the decision in Louisville Trust Co. v. Louisville, N.A.&C.

Railroad Co., 174 U.S. 674, 684 (1899), stated that “any

arrangement of the parties by which the subordinate rights and

interests of the stockholders are attempteg to be secured at the

expense of the prior rights of either class of creditors comes

within judicial denunciation.” 308 U.S. at 116; (ii) Northern

Pacific Railway Co. v. Boyd, 228 U.S. 482, 508 (1913) was quoted as

support for the proposition that “value, whether it was present

or prospective, for dividends or only for purposes of control... ..

was a right of property out of which the creditors were entitled

to be paid before the stockholders could retain it for any

purpose whatever.” /d.; (iii) Justice Douglas quotes Kansas City

Terminal Railway Co. v. Central Union Trust Co., 271 U.S. 445, 455

(1926), for the proposition that “to the extent of their debts

creditors are entitled to priority over stockholders against all

the property of an insolvent corporation,” 308 U.S. at 120, and

concludes that the proposed plan did not “recognize the

‘equitable right’ of the bondholders to be preferred to

stockholders against the full value of all property belonging to

the debtor corporation . . . since the full value of that property is

not first applied to claims of the bondholders before the

stockholders are allowed to participate” Id.; and quoting Kansas

City Terminal again, Justice Douglas stated that when

“assessments are demanded, they must be adjusted with the

purpose of according to the creditor his full right of priority

against the corporate assets, so far as possible in the existing

circumstances.” 308 U.S. at 121.

13

hardly seem to accord the creditor its “full right of prior-

ity.” 1°

Thus, by not affording the creditor its full right of

priority, the LaSalle debtor’s plan did not meet this

requirement of the new value corollary to the absolute

priority rule, was not fair and equitable, and should not

have been confirmed over the objection of an impaired

class of creditors.

'© How the standards of the Case dicta can be achieved has

been the source of much controversy. Professors Ayer and

Markell apparently believe that the requirements of the Case

dicta can never be achieved. See Ayer, supra, at 1016; Markell,

supra, at 92-93. However other theories have been articulated

that would seem to achieve in large measure the balance Justice

Douglas was looking for. For example, it has been suggested

that the interest of the new value contributor be determined

based on a sharing of the equity. Under this theory, the

enterprise value prior to the infusion of new value remains with

the creditors. The interest of old equity will be determined by

comparing the capital infusion to the value of the enterprise

after the infusion. Since this theory does not deal with the issue

of how control would be valued (especially significant in an

enterprise with little or no value) an alternative theory, based on

the proposition that the entire value of the enterprise, including

control, belongs to the unpaid creditors and thus the interest of

old equity should be measured by comparison to the amount of

unpaid debt. These theories are discussed in greater detail in

Robert M. Zinman, New Value and the Commission: How Bizarre!,

5 Am. Bankr. Inst. L. Rev. 477, 487-90 (1997). No attempt at

meeting the “full right of priority” prong of Justice Douglas’

dicta was even attempted in LaSalle.

14

B. The Seventh Circuit Distorts the Other Prereq-

uisites to New Value Articulated by this Court

in Case.

As discussed above, under the dicta in Case, a plan in

which old equity retains an interest might be confirmed

upon a contribution of new value in the form of money or

money’s worth only if the full priority rights of creditors

are preserved. In order to preserve those priority rights,

Justice Douglas stated that certain prerequisites must be

met. First, the new value must be necessary or “ ‘essential

to the success of the undertaking’,” 308 U.S. at 121 (quoting

Kansas City Terminal Ry. Co. v. Central Union Trust Co., 271

U.S. 445, 455 (1926)) (emphasis added); and second, the

contribution must be “reasonably equivalent in view of

all the circumstances to the participation of the stock-

holder.” 308 U.S. at 122. In LaSalle, the requirements of

necessity and reasonable equivalence have been so dis-

torted that in reality they no longer are prerequisites to

confirmation of a new value plan. In large measure, they

have been dissolved in a new amorphous requirement of

substantiality that seems to have no objective standards

to determine if it has been met.

1. The Seventh Circuit distorts the require-

ment that the contribution be essential to

the success of the undertaking.

When Justice Douglas referred to the “necessity, at

times, of seeking new money ‘essential to the success of

the undertaking’,” 308 U.S. at 121 (quoting 271 US. at

455), he was referring to the necessity for funds to con-

tinue the operation of the enterprise, the production of its

15

product, the provision of its services, and the employ-

ment of its workers. In single asset real estate cases, such

as LaSalle, it is difficult to find this necessity. There is no

business to be continued, no product to be produced, and

no service to be performed that will not be continued,

produced, or performed by the new owner of the real

estate.

Confronted with the fact that funds were not essen-

tial to the success of the undertaking in LaSalle, the Sev-

enth Circuit distorted the necessity requirement to mean

essential for confirmation of the debtor’s plan! (“The

infusion of new capital was necessary for the successful

implementation of the plan.” 126 F.3d at 967). Since new

value is always proposed by the debtor to enable old

equity to keep the property under the plan, this switch in

the meaning of “necessary” would result in virtually

every new value plan meeting the necessity requirement.

In effect the Seventh Circuit is saying that the debtor may

wipe out the creditors’ interests if that is the only way old

equity can retain the property while leaving the debtor's

debts unpaid. This effectively reads “essential to the suc-

cess of the enterprise” out of the prerequisites for new

value plan confirmation.

2. Reasonable equivalence is eliminated in no-

equity situations.

Under the prerequisite of reasonable equivalence, old

equity may not receive more than the reasonable equiva-

lence of its contribution. In single asset cases, the debtor

usually has no equity in the property (the property value

is equal to or lower than the mortgages encumbering it),

16

as was the case in LaSalle where the asset was valued at

$54.5 million but was encumbered by Bank of America’s

mortgage of $93 million, leaving a deficiency claim of

$38.5 million, 84% of which was wiped out under the

debtor’s new value plan. In the past, debtors have argued

that retention of the property by old equity does not

deprive the creditor of its full right of priority because

what the debtor proposes to retain is worthless. This

Court has clearly rejected this “no-value” argument. In

Northern Pacific Railway Co. v. Boyd, 228 U.S. 482, 508

(1913), this Court stated that “control” itself was an asset

that constituted value and that such value belonged to

the creditors, not old equity. This Court again, in 1988,

reaffirmed that determination in Norwest Bank Worth-

ington v. Ahlers, 485 U.S. 197 (1988), stating that “we join

with the consensus of authority which has rejected this

‘no value’ theory.” Id. at 207.

The LaSalle bankruptcy court seemed to have no diffi-

culty in ignoring these decisions when it employed the

no-value theory as the basis for determining that the

contribution met the reasonable equivalence standard.

The Bankruptcy Court stated that “the contribution is

easily the equivalent of the interests retained by the

debtor’s partners. Indeed, on the market, those interests

are worthless.” 190 B.R. at 588. The Seventh Circuit

merely acknowledged that the Bankruptcy Court had

determined that the contribution was “reasonably equiva-

lent to the interest retained” and failed to discuss how or

on what basis the requirement had been met, apparently

agreeing with the Bankruptcy Court’s approach. See 126

F.3d at 967.

17

LaSalle, then, reads the “reasonably equivalent” pre-

requisite out as a condition to new value plan confirma-

tion, at least in those cases where the debtor has no

equity in the property.

3. The new requirement of substantiality

serves as a smoke screen for the failure to

follow the Case prerequisites.

When the new value principle was rediscovered and

revised after the adoption of the Bankruptcy Code, a new

prerequisite was added by the courts, which required that

the contribution be substantial. The Seventh Circuit

referred to this requirement as a corollary of the require-

ment of necessity. See In re Snyder, 967 F.2d 1126, 1131 (7th

Cir. 1992). Other decisions of the Seventh Circuit have

seen the substantiality requirement as a summary of all

other factors, which means that if the contribution is

substantial, it meets at least the necessity and reasonable

equivalence requirements. This “substitute” theory is

articulated in the bankruptcy court decision in LaSalle,

where the court understood the decision in In re Wood-

brook Associates, 19 F.3d 312, 320 (7th Cir. 1994), to imply

that “substantiality serves as something of a summary of

the other factors.” 190 B.R. at 587. This conclusion is

obviously a non-sequitur of major proportions. While a

nominal contribution might be an indication that the

contribution is not necessary for the success of the enter-

prise, it does not follow that a large contribution is neces-

sary. As for reasonable equivalence, one cannot consider

whether a contribution of any size is reasonably equiva-

lent in the abstract; one must first determine the value of

18

the interest to which the contribution is supposed to be

reasonably equivalent.

The unique aspect of the substantiality requirement

is that there appear to be no standards to determine

whether it has been met. The Seventh Circuit in LaSalle

quotes other decisions in that Circuit stating that the

contribution cannot be “merely nominal, or gratuitous.”

126 F.3d at 967 (citations omitted). Beyond that, “ ‘[w]hether

the infusion of new capital is ‘substantial’ is more a

common sense determination than a mathematical calcu-

lation when the debtor comprises only a single real estate

asset which is fully encumbered.’” Id. (quoting Wood-

brook, 19 F.3d at 320). This common sense determination is

made by looking to whether the contribution is “real and

necessary to the successful implementation of the plan.”

Id. (emphasis added). The Seventh Circuit approved the

Bankruptcy Court’s determination that the amount was

substantial in both abselute terms, see 126 F.3d at 967

(comparing contribution with dollar amounts approved

in other cases), and its impact on the case. See id. (measur-

ing the contribution as a percentage of the unsecured

debt in this case as compared to others).

The circularity of the Seventh Circuit’s discussion of

substantiality begins with reading into the Bankruptcy

Code the pre-Code dicta of this Court, strictly limited by

prerequisites. The next step is to incorporate a new pre-

requisite of substantiality and determine that it serves as

a summary of the prerequisites in the pre-Code dicta, thus

permitting the court to ignore or give scant attention to

them. Then the court determines that whether substan-

tiality is met is a subjective determination with virtually

no objective standards. The result appears to be that only

— oe a ae een mee

19

the words “new value” survived the adoption of the

Bankruptcy Code but not the standards by which the new

value corollary would be met.

- By ignoring the creditor priority prong of this court's

new value dicta, and then distorting both the necessity

and reasonable equivalence prerequisites and subordinat-

ing them to a new amorphous requirement of substan-

tiality, the Seventh Circuit has converted the Case corollary

to a wide exception to the absolute priority rule that

threatens to consume the rule itself. We respectfully urge

that the Seventh Circuit be reversed.

Ill. THE APPLICATION OF THE SEVENTH CIR-

CUIT’S VERSION OF NEW VALUE TO SINGLE

ASSET REAL ESTATE REORGANIZATIONS

WOULD SERVE NO PUBLIC PURPOSE, ABRO-

GATE THE PROTECTION FOR MORTGAGEES

BUILT INTO THE BANKRUPTCY CODE, AND

HAVE A SEVERE NEGATIVE IMPACT ON BOR-

ROWERS, LENDERS AND THE REAL ESTATE

INDUSTRY.

A. No Public Purpose.

The confirmation of new value plans is often urged

as a matter of public policy on the ground that the funds

are needed to keep the debtor in business, preserve the

going concern value, keep people employed, and pre-

serve the performance or production of needed services

or products. Whether or not such arguments make sense

in the case of a manufacturer or service provider, these

laudable objectives are wholly inapplicable to single asset

real estate cases. In the single asset real estate transaction

the operation of the real estate will continue no matter

20

who is the owner of the property. It is inappropriate to_

say that the “reorganization will fail” if there is no infu-

sion of new value. The only thing that may fail is the

attempt by old equity to keep the debtor’s property with-

out paying its just debts."

If the debtor’s plan cannot be confirmed and the

property goes to foreclosure, the mortgagee or other pur-

chaser at the sale will operate the property. The question

is not whether the business will continue; the question is

only who will own the property — the debtor’s old equity

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

or the creditors who have not been paid. The decision

below opts for the former, with old equity given the

property and 84% of the creditor’s deficiency claim

wiped out. No public purpose can be served by such a

result.

'! The Seventh Circuit does not appear to recognize the

distinction between a corporate entity that is an active business

and a single asset real estate partnership, which does not have

an active business but is primarily a vehicle for owning real

estate. In concluding that new value survived the adoption of

the Bankruptcy Code, the court states that to conclude

otherwise would assume that Congress, without addressing the

issue, made a decision “affecting the economic health, and

indeed the continued existence, of many corporate entities.” 126

F.3d at 966 (emphasis added). While there are, of course, some

corporations that are single asset entities, the purpose of the

court’s example is to describe the effect of bankruptcy on going

businesses, seemingly without appreciation of the fact that most

single asset entities are partnerships like LaSalle, without a

going business to be concerned about.

21

B. Abrogation of Mortgagee Protection.

Section 1129(b)(2)(B)(ii) of the Bankruptcy Code pro-

hibits confirmation of a plan over the objection of an

impaired class of unsecured creditors if old equity is

permitted to retain an interest in the property on account

of its junior interest. A major reason for this provision

was to overcome the so-called Pine Gate line of cases that

treated nonrecourse mortgagees as the Seventh Circuit

now treats all mortgagees. In In re Pine Gate Associates,

Ltd., 2 Bankr. Ct. Dec. (CRR) 1478 (Bankr. N.D. Ga. 1976),

and its progeny, decided under chapter XII of the former

Bankruptcy Act, the bankruptcy courts allowed debtors

to retain the mortgaged property upon payment to the

non-recourse mortgagee of the depressed (due to the

mid-70’s recession) value of the collateral.'? In direct

response to the perceived inequity of the Pine Gate line of

cases, Congress was asked to restore absolute priority to

real estate arrangements under the new chapter 11 of the

Bankruptcy Code. See, e.g., Hearings on S. 2266 and H.R.

8200 Before the Subcomm. on Improvements in the Judicial

Machinery of the Senate Comm. on the Judiciary, 95th Cong.

853, 855-56, 864-76 (1977) (statement of John J. Creedon,

American Council of Life Insurance).

Congress enacted a package of protection insuring

that the mortgagee may have an unsecured claim for the

deficiency, see 11 U.S.C. § 506(a), and providing absolute

12 In State Mutual Assurance Co. of America v. KRO Associates

(In re KRO Associates), 4 Bankr. Ct. Dec. (CRR) 462, 463, 470

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

mortgages on the property. The court, using a 20% capitalization

rate, found the value of the property to be $895,000.

22

priority for each dissenting impaired class of crec ‘ors,

including the unsecured class. See 11 U.S.C. § 1129b)(2).

It was this absolute priority for the unsecured class,

including the mortgagee’s deficiency claim, that provided

the protection afforded by Congress. If the unsecured

class rejected the plan (and normally in single asset cases

the mortgagee’s deficiency claim is the only major

unsecured claim) the debtor would not be able to retain

the property without paying the creditors. Such a plan

could not be confirmed.

New value as applied in LaSalle and many post enact-

ment Bankruptcy Code cases would abrogate this protec-

tion by essentially restoring the Pine Gate rule —- in a much

more sinister form. In both situations the debtor would

keep the property. The difference is that under Pine Gate,

the mortgagee would receive an immediate payment of

cash equal to the court determined value of the collateral,

whereas in the new value cases after the enactment of the

Bankruptcy Code, the mortgagee could receive only a

mortgage with a face amount equal to the court deter-

mined value of the collateral. This retention of the prop-

erty by old equity when portions of, or all of, the

mortgagee’s deficiency claim is wiped out is clearly the

opposite of what Congress intended. See S. Rep. No.

95-598, at 65 (1978), reprinted in 1978 U.S.C.C.A.N. 5787,

5851 (stating that a precursor of present § 1111(b), which

affords a deficiency claim to nonrecourse mortgagees,

“answers the nonrecourse loan problem and gives the

creditor an unsecured claim for the difference between

the value of the collateral and the debt in response to the

decision in” Pine Gate); see also In re DRW Property Co. 82,

57 B.R. 987, 990 (Bankr. N.D. Tex. 1986) (stating Congress

23

enacted § 1111(b) “to alleviate the Pine Gate problem and

to attempt to restore the benefit of the bargain to the non-

recourse secured creditor”).

It should be apparent that new value, as interpreted

by the Seventh Circuit, would undo the absolute priority

protection afforded by Congress to mortgagees. This

would represent a major adverse change in the treatment

of mortgages in bankruptcy.

C. Negative Impact on the Real Estate Industry.

The decision below will have a severe adverse impact

on the real estate industry. Literally billions of dollars

have been loaned to real estate developers by institutions,

including insurance companies and pension plans that

insure and protect millions of ordinary citizens, on the

strength of real property collateral and the protection for

realization on that collateral built into the Bankruptcy

Code. Mortgage loans are securitized, rated and sold to

investors seeking the security of the mortgage collateral.

These purchasers include individual investors and pen-

sion funds, as well as institutions investing poli-

cyholders’ funds and deposits from individuals and

corporations, all of whom make these investments based

on the ability to realize the benefit of the bargain if there

is a default in the income flow.

The decision below can only result in the severe

reduction of the availability of funds for real estate devel-

opment from institutions and from the public, and tighter

credit standards and higher interest rates for those funds

that are available or those securities that are sold. LaSalle

not only threatens existing mortgage debt held by

24

lenders, but also threatens the future of the real estate

and real estate securities industry.

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

cases in the United States. If Courts are permitted by

judicial legislation to undermine the foundations of the

protection afforded to real estate mortgagees, the real

estate industry and the national economy, will be severely

and adversely affected.

CONCLUSION

For all the reasons set forth herein, the American

College of Real Estate Lawyers respectfully urges that the

decision of the Seventh Circuit be reversed.

Respectfully submitted,

Of Counsel Counsel of Record

Pror. Rosert M. ZINMAN

St John’s University

School of Law

8000 Utopia Parkway

Jamaica, New York 11439

THomas C. HOMBURGER (718) 990-6646

Co-Chair, Amicus Briefs

Committee, American College

of Real Estate Lawyers

Cari J. Senexer, Il

President, American

College of Real

Estate Lawyers

CHRISTOPHER F. GRAHAM

THACHER Prorritt & Woop