In Re Castleton Plaza, LP , 707 F.3d 821 ( 2013 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 12-2639
IN THE M ATTER OF:
C ASTLETON P LAZA , LP,
Debtor.
A PPEAL OF:
EL-SNPR N OTES H OLDINGS, LLC
Appeal from the United States Bankruptcy Court
for the Southern District of Indiana, Indianapolis Division.
No. 11-01444-BHL-11—Basil H. Lorch III, Judge.
A RGUED D ECEMBER 6, 2012—D ECIDED F EBRUARY 14, 2013
Before E ASTERBROOK, Chief Judge, and F LAUM and
R OVNER, Circuit Judges.
E ASTERBROOK, Chief Judge. Creditors in bankruptcy are
entitled to full payment before equity investors can
receive anything. 11 U.S.C. §1129(b)(2)(B)(ii). This is
the absolute-priority rule. Equity investors sometimes
contend that the value they receive from the debtor in
bankruptcy is on account of new (post-bankruptcy)
investments rather than their old ones. The Supreme
2 No. 12-2639
Court held in Bank of America National Trust & Savings
Ass’n v. 203 North LaSalle Street Partnership, 526 U.S.
434 (1999), that competition is the way to tell whether
a new investment makes the senior creditors (and the
estate as a whole) better off. A plan of reorganization
that includes a new investment must allow other
potential investors to bid. In this competition, creditors
can bid the value of their loans. RadLAX Gateway Hotel,
LLC v. Amalgamated Bank, 132 S. Ct. 2065 (2012).
The process protects creditors against plans that
would give competing claimants too much for their new
investments and thus dilute the creditors’ interests.
This appeal presents the question whether an equity
investor can evade the competitive process by arranging
for the new value to be contributed by (and the new
equity to go to) an “insider,” as 11 U.S.C. §101(31) defines
that term. The bankruptcy judge answered yes; our
answer is no. Competition is essential whenever a plan
of reorganization leaves an objecting creditor unpaid
yet distributes an equity interest to an insider.
The material facts are simple. Castleton Plaza, the
debtor, owns a shopping center in Indiana. George
Broadbent owns 98% of Castleton’s equity directly and
the other 2% indirectly. EL-SNPR Notes Holdings is its
only secured lender. The note carries interest of 8.37%
and has several features, such as lockboxes for ten-
ants’ rents and approval rights for major leases, de-
signed for additional security. The note matured in
September 2010, and Castleton did not pay. Instead it
commenced a bankruptcy proceeding. About a year later
No. 12-2639 3
Castleton proposed a plan of reorganization under
which $300,000 of EL-SNPR’s roughly $10 million
secured debt would be paid now and the balance written
down to roughly $8.2 million, with the difference
treated as unsecured. The $8.2 million secured loan
would be extended for 30 years, with little to be paid
until 2021, and the rate of interest cut to 6.25%, excep-
tionally low for credit representing 97% of the estimated
value of the borrower’s assets. All of the note’s extra
security features, such as the rental lockbox and
approval rights, would be abolished.
Unpaid creditors normally receive the equity in a
reorganized business. Castleton proposed a plan that
cut the creditors out of any equity interest. Since the
plan pays EL-SNPR less than its contractual entitlement,
§1129(b)(2)(B)(ii) provides that George Broadbent cannot
retain any equity interest on account of his old invest-
ment—and 203 North LaSalle requires an auction before
he could receive equity on account of a new invest-
ment. The proposed plan of reorganization nominally
left George empty-handed. But it provided that 100%
of the equity in the reorganized Castleton would go
to Mary Clare Broadbent, George’s wife, who would
invest $75,000. Mary Clare owns all of the equity in
The Broadbent Company, Inc., which runs Castleton
under a management contract. George is the CEO of
The Broadbent Company and receives an annual salary
of $500,000 for his services. The plan of reorganization
provides that the management contract between
Castleton and The Broadbent Company would be con-
tinued.
4 No. 12-2639
EL-SNPR believes that Castleton’s assets have been
undervalued—see 2011 Bankr. L EXIS 3804 (Bankr. S.D.
Ind. Sept. 30, 2011) (estimating the real estate’s value at
$8.25 million)—and that, given the dramatic decrease in
the amount Castleton owes on the loan, the equity in
the reorganized business will be worth more than
$75,000. Cf. In re River East Plaza, LLC, 669 F.3d 826(7th Cir. 2012). It offered $600,000 for the equity and
promised to pay all other creditors 100¢ on the dollar.
(Castleton’s plan, by contrast, offers only 15% on unse-
cured claims, paid over five years.) Castleton rejected
this proposal, though a revised plan did increase
Mary Clare Broadbent’s investment to $375,000.
EL-SNPR asked the bankruptcy judge to condition that
plan’s acceptance on Mary Clare making the highest
bid in an open competition. But the bankruptcy judge
held that competition is unnecessary and confirmed
the plan as proposed.
The judge certified a direct appeal under 28 U.S.C.
§158(d)(2)(A). We accepted it because no court of appeals
has addressed, after 203 North LaSalle, whether competi-
tion is essential when a plan of reorganization gives an
insider an option to purchase equity in exchange for
new value. Bankruptcy judges have disagreed on the
answer; we do not attempt to catalog the decisions.
The bankruptcy court thought competition unneces-
sary because Mary Clare Broadbent does not own an
equity interest in Castleton, and §1129(b)(2)(B)(ii) deals
only with “the holder of any claim” that is junior to the
impaired creditor’s claim. Yet 203 North LaSalle did not
No. 12-2639 5
interpret the language of §1129(b)(2)(B)(ii), which does
not speak to new-value plans. The Court devised
the competition requirement to curtail evasion of the
absolute-priority rule. A new-value plan bestowing
equity on an investor’s spouse can be just as effective
at evading the absolute-priority rule as a new-value
plan bestowing equity on the original investor. For
many purposes in bankruptcy law, such as preference
recoveries under 11 U.S.C. §547, an insider is treated the
same as an equity investor. Family members of corporate
managers are insiders under §101(31)(B)(vi). In 203
North LaSalle the Court remarked on the danger that
diverting assets to insiders can pose to the absolute-
priority rule. 526 U.S. at 444. It follows that plans giving
insiders preferential access to investment opportunities
in the reorganized debtor should be subject to the
same opportunity for competition as plans in which
existing claim-holders put up the new money.
There can be no doubt that George Broadbent would
receive value from the equity that Mary Clare Broadbent
stands to obtain under the plan of reorganization. One
form of value would be the continuation of George’s
salary as CEO of The Broadbent Company. Another
would come through an increase in the family’s wealth.
Indiana is not a community-property state, but one
spouse usually receives at least an indirect benefit from
another’s wealth, and Indiana treats each spouse as
having a presumptive interest in the other’s wealth. See
Ind. Code §31-15-7-4. The fact that each spouse’s wealth
benefits the whole family is a principal reason why the
statutory definition of insider includes family mem-
6 No. 12-2639
bers—and why federal judges must recuse themselves
when spouses or children living in the household have
financial interests in litigants. 28 U.S.C. §455(b)(4). And
we cannot overlook the fact that George Broadbent,
through his control of Castleton, set the option’s price
at $75,000 (and then $375,000) rather than some higher
number. The difference between $375,000 and the price
the option would fetch in competition is value to the
entire Broadbent family.
In tax law, the exercise of a general power of appoint-
ment is treated as income to the holder. See Jewett v. CIR,
455 U.S. 305, 318 (1982). Thus if George Broadbent had
directed The Broadbent Company to remit some of his
salary to his spouse, child, or the supplier of the family’s
new piano, the money still would be treated as income
to George and taxed accordingly. Similarly, if George
had a discretionary power under a trust, and could
direct assets to either Mary Clare or himself, the value
would be treated as income to George even if the trust
paid Mary Clare. That’s fundamentally what happened
here. George had control over Castleton and used his
authority to propose a plan that directed a valuable
opportunity (an option to buy all of the equity in the
reorganized firm) to his spouse. Cf. Kham & Nate’s Shoes
No. 2 v. First Bank of Whiting, 908 F.2d 1351, 1360 (7th Cir.
1990). Since the exercise of a power of appointment
is treated as income in tax law, it should be treated as
income for the purpose of §1129(b)(2)(B)(ii) too. Thus,
under the plan of reorganization, George receives value
on account of his investment, which gave him control
over the plan’s details. The absolute-priority rule
therefore applies despite the fact that Mary Clare had not
No. 12-2639 7
invested directly in Castleton. This reinforces our con-
clusion that competition is essential. In re Wabash Valley
Power Association, Inc., 72 F.3d 1305, 1313–20 (7th Cir.
1995), on which Castleton relies, does not hold other-
wise—and at all events Wabash predates 203 North LaSalle
and RadLAX. The Supreme Court’s decisions must prevail.
None of the considerations we have mentioned
depends on whether Castleton proposed the plan
during the exclusivity period. See 11 U.S.C. §1121(b) (only
a trustee or debtor in possession may propose a plan
of reorganization during the first 120 days, or any addi-
tional time allowed by the bankruptcy judge). Nor does
the rationale of 203 North LaSalle depend on who
proposes the plan. Competition helps prevent the fun-
neling of value from lenders to insiders, no matter
who proposes the plan or when. An impaired lender
who objects to any plan that leaves insiders holding
equity is entitled to the benefit of competition. If, as
Castleton and the Broadbents insist, their plan offers
creditors the best deal, then they will prevail in the
auction. But if, as EL-SNPR believes, the bankruptcy
judge has underestimated the value of Castleton’s real
estate, wiped out too much of the secured claim, and set
the remaining loan’s terms at below-market rates, then
someone will pay more than $375,000 (perhaps a lot
more) for the equity in the reorganized firm.
The judgment of the bankruptcy court is reversed, and
the case is remanded with directions to open the pro-
posed plan of reorganization to competitive bidding.
2-14-13