The Absolute Priority Rule and the “New Value” Exception

The absolute priority rule is codified in section 1129(b)(2)(B)(ii) of the Bankruptcy Code. This section requires that for a reorganization plan to be fair and equitable “the holder of any claim or interest that is junior 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.A. § 1129(b)(2)(B)(ii). This rule governs the order of payment among creditors. Senior creditors are paid in full before junior creditors are paid, unless the senior creditors consent to subordinate their claims. Junior classes of creditors and equity holders (meaning the shareholders / directors / officers of a corporate filer, or the filer of an individual case) cannot receive property of a debtor during a reorganization unless all senior classes are either paid in full or vote in favor of the plan. In other words, equity interest holders are not permitted to keep their equity under a plan if all senior claims are not paid in full. Practically, many debtors cannot satisfy the claims of their creditors, and creditors are thus put in a position whether they can foreclose on assets/own the company.

Because most creditors do not want to run the reorganized business, and because debtors can get around the Absolute Priority Rule by contributing New Value, they will generally negotiate with the debtor to come up with different solutions. Even if creditors do not consent to the debtor retaining ownership, the debtor may still do so if a plan of reorganization retaining ownership of the company is confirmed. In Zachary v. California Bank & Trust, the 9th Circuit ruled that the absolute priority rule also applied in individual chapter 11 cases. Zachary v. California Bank & Trust, 811 F.3d 1191 (9th Cir. 2016).

The new value exception allows old equity holders to retain ownership in the company despite the absolute priority rule. Old equity holders may retain their interests by contributing new money or money’s worth that is substantial and vital to the reorganization effort. In order to take advantage of the New Value exception to the absolute priority rule equity holders must offer value that is (1) new; (2) substantial; (3) money or money’s worth; (4) necessary for a successful reorganization, and (5) reasonably equivalent to the value or interest received. If a proposed plan satisfies all of these new value exception requirements, it will not violate the absolute priority rule, and a plan can be confirmed where creditors are not paid in full and the debtor’s equity holders retain their interests in full.

Keep in mind that what constitutes New Value is a highly fact-intensive question. Also, different creditors present varying degrees of objection, some more strenuous than others, and judges also have varying views on what is sufficient.