7th Circuit Remands|Bankruptcy Plan

CHICAGO (CN) - The 7th Circuit rejected a reorganization plan from the owner of a bankrupt Indiana shopping center, ruling that a competition must be held to determine whether the plan will be the best deal for creditors.

Castleton Plaza LP declared bankruptcy in September 2010. The company, owned in its entirety by George Broadbent, has only one secured lender, EL-SNPR Notes Holdings.

One year after the Chapter 11 filing, Castleton proposed a reorganization plan which would pay $300,000 of EL-SNPR's $10 million secured debt immediately, provided that the balance be written down to $8.2 million, and reduced the interest rate on EL-SNPR's loan from 8.37 percent to 6.25 percent.

The proposal also gave 100 percent of the equity in the reorganized Castleton to Mary Clare Broadbent, George Broadbent's wife, who would invest $75,000 in the company.

Mary Clare Broadbent is owner of The Broadbent Company, which employs George Broadbent as CEO at an annual salary of $500,000.

Believing that Castleton had been undervalued, EL-SNPR submitted its own reorganization proposal, which offered $600,000 for equity in Castleton and promised to pay unsecured creditors 100 cents on the dollar.

Castleton's plan offered only 15 percent on unsecured claims.

Castleton rejected the proposal but increased Mary Clare Broadbent's investment to $375,000.

Despite EL-SNPR's calls for an open competition, U.S. District Judge Basil Lorch accepted Castleton's plan.

Lorch reasoned that because Mary Clare Broadbent had not directly invested in Castleton, she had no equity interest in the company before the bankruptcy filing. Thus the Supreme Court's competition requirement set forth in Bank of America National Trust & Savings Association v. 203 North LaSalle Street Partnership did not apply.

But the 7th Circuit reversed Lorch's ruling, noting that the competition process is intended to protect creditors against plans that dilute their interests by giving claimants too much for their investments.

"Competition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider," Chief Judge Frank Easterbrook wrote for the three-judge panel.

Under the "absolute-priority" rule, creditors in bankruptcy are entitled to full payment before equity investors can receive anything, though equity investors can sometimes recover from the debtor if the value they receive is on account of post-bankruptcy investments rather than their old ones.

"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," Easterbrook wrote.

George Broadbent would receive value from the equity given to Mary Clare both because of his salary as CEO of The Broadbent Company and because of the resulting increase in the family's wealth.

"Competition helps prevent the funneling 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," Easterbrook wrote.

"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 7th Circuit reversed and remanded with instructions to open the reorganization plan to competitive bidding.

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