Cramdown of Equity in Chapter 11 Plan Requires Assessment of Equity's Value to Satisfy "Fair and Equitable" Standard
Chapter 11 plans that propose to extinguish existing equity interests because the estate does not have any value remaining after the payment of creditor claims are common. The Bankruptcy Code's "absolute priority rule" provides that a plan can be confirmed over the objections of more senior classes of creditors or interest holders that are not receiving full payment only if junior classes do not retain or receive anything under the plan on account of their claims or interests.
There is a paucity of case law, however, addressing whether the proponent of a chapter 11 extinguishing purportedly out-of-the-money equity must demonstrate that the equity is worthless to satisfy the Bankruptcy Code's requirements for nonconsensual confirmation. The U.S. Bankruptcy Court for the Southern District of New York examined this question in In re Global Fertility & Genetics New York, LLC, 663 B.R. 584 (Bankr. S.D.N.Y. 2024). The court ruled that in cases involving a chapter 11 plan that proposes to pay all creditors in full while canceling equity interests for no consideration, the "fair and equitable" standard for cramdown confirmation requires an assessment of the value of the equity and whether the transaction is fair to equity holders.
Cramdown Chapter 11 Plans
If a class of creditors or shareholders votes (or is deemed) to reject a chapter 11 plan, it can be confirmed only if the plan satisfies the "cramdown" requirements of section 1129(b) of the Bankruptcy Code. Among those requirements are the mandates that, with respect to dissenting classes of creditors and shareholders: (i) the plan must be "fair and equitable"; and (ii) the plan must not "discriminate unfairly." 11 U.S.C. § 1129(b)(1).
Fair and Equitable. Section 1129(b)(2)(B) of the Bankruptcy Code provides that "the condition that a plan be fair and equitable with respect to [an unsecured] class includes" the requirement that creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, if no creditor or equity holder of lesser priority receives any distribution under the plan. 11 U.S.C. § 1129(b)(2)(B) (emphasis added).
Section 1129(b)(2)(C) provides that a plan is fair and equitable with respect to a dissenting impaired equity class if either: (i) each equity holder in the class receives or retains property of a value on the effective date "equal to the greatest allowed of any fixed liquidation preference to which such holder is entitled, and fixed redemption price to which such holder is entitled, or the value of such interest; or (ii) any junior equity holders do not receive or retain anything under the plan. 11 U.S.C. § 1129(b)(2)(C).
These requirements are commonly referred to as the "absolute priority rule," which was derived in part from common law and practice under the former Bankruptcy Act of 1898 (as amended).
A "new value exception" to the absolute priority rule was developed under pre-Bankruptcy Code law. See Case v. Los Angeles Lumber Prods. Co., 308 U.S. 106 (1939). Under this exception, a junior stakeholder (e.g., a shareholder or subordinated creditor) could retain an equity interest under a chapter 11 plan over the objection of a senior impaired-creditor class, provided that the junior stakeholder contributed new capital to the restructured enterprise. According to some courts, that contributed capital must be: (i) new; (ii) substantial; (iii) necessary for the success of the plan; (iv) reasonably equivalent to the value retained; and (v) in the form of money or money's worth. See, e.g., In re Crowe, 2021 WL 2212005 (Bankr. D. Ariz. June 1, 2021).
Court disagree as to whether the new value exception survived the enactment of the Bankruptcy Code in 1978, principally because the concept is not explicitly referred to in section 1129(b)(2) or elsewhere in the statute. See generally Collier on Bankruptcy ("Collier") ¶ 1129.03[4](c) (16th ed. 2024) ("One of the more hotly contested issues after adoption of the Code has been whether the so-called "new value" cases continued to have validity. The Supreme Court has three times declined to rule on the matter, and the circuit courts are currently in disarray. Other appellate courts tend to favor the doctrine's existence, but some are unsure. Each side has arguments to make.") (footnotes omitted).
Since the enactment of the Bankruptcy Code, the U.S. Supreme Court has only obliquely addressed the legitimacy of the new value exception. In its most recent ruling addressing the issue—Bank of Am. Nat. Tr. & Sav. Ass'n v. 203 N. LaSalle St. P'ship, 526 U.S. 434 (1999), the Court held that one or two of the five elements of the new value corollary could not be satisfied when old equity retains the exclusive right to contribute the new value―i.e., without a market test of the new value.
No Unfair Discrimination. The Bankruptcy Code does not define "unfair discrimination," and "[c]ourts have struggled to give the unfair discrimination test an objective standard." Collier at ¶ 1129.03[a]. Nevertheless, most courts agree that the purpose underlying the requirement is "to ensure that a dissenting class will receive relative value equal to the value given to all other similarly situated classes." In re LightSquared Inc., 513 B.R. 56, 99 (Bankr. S.D.N.Y. 2014); accord In re SunEdison, Inc., 575 B.R. 220 (Bankr. S.D.N.Y. 2017); In re 20 Bayard Views, LLC, 445 B.R. 83 (Bankr. E.D.N.Y. 2011); In re Johns-Manville Corp., 68 B.R. 618, 636 (Bankr. S.D.N.Y. 1986), aff'd, 78 B.R. 407 (S.D.N.Y. 1987), aff'd, 843 F.2d 636 (2d Cir. 1988).
Courts have historically relied on a number of tests to determine whether a plan discriminates unfairly. One of those is the unfair discrimination test (the "Markell test") articulated by Bruce A. Markell in his article "A New Perspective on Unfair Discrimination in Chapter 11," 72 Am. Bankr. L.J. 227, 249 (1998). See, e.g., In re Armstrong World Indus., Inc., 348 B.R. 111 (D. Del. 2006); In re Quay Corp., Inc., 372 B.R. 378 (Bankr. N.D. Ill. 2007); In re Exide Techs., 303 B.R. 48 (Bankr. D. Del. 2003). The Markell test was first applied by a bankruptcy court in In re Dow Corning Corp., 244 B.R. 705 (Bankr. E.D. Mich. 1999), aff'd in relevant part, 255 B.R. 445 (E.D. Mich. 2000), aff'd in part and remanded, 280 F.3d 648 (6th Cir. 2002). Under the Markell test, a rebuttable presumption that a plan unfairly discriminates will arise when the following elements exist:
(1) a dissenting class; (2) another class of the same priority; and (3) a difference in the plan's treatment of the two classes that results in either (a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments), or (b) regardless of percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution.
Id. at 710. The burden then lies with the plan proponent to rebut the presumption by demonstrating that "outside of bankruptcy, the dissenting class would similarly receive less than the class receiving a greater recovery, or that the alleged preferred class had infused new value into the reorganization which offset its gain." Id.
Global Fertility
Global Fertility & Genetics, New York, LLC (the "debtor") owns and operates a fertility clinic in New York City principally serving patients from China. It is wholly owned by GFG Holding Group Co., LLCC ("GFG"), the ownership interests of which are held by Chinese investor Dr. Hu Bo (70%), Jun Jing Liu (15%), and Dr. Keven J. Doody (15%). Because New York law prohibits the "corporate practice" of medicine, the debtor does not itself provide medical services. Instead, those services are provided by Doody's medical practice, KJD Medical, PLLC ("KJD"), and the debtor provides medical equipment and is responsible for management and administrative services under an administrative services agreement (the "ASA"). Under that agreement, which the parties dispute was ever finalized or signed, KJD collects revenues from medical services and pays the debtor $1.5 million plus expenses annually.
Prior to the debtor's chapter 11 filing on June 6, 2023, in the Southern District of New York, Hu made more than $10 million in capital contributions to the debtor, which has lost money every year since its inception in 2016. Hu made additional cash contributions post-petition totaling more than $150,000. At the time of the bankruptcy filing, the debtor had no funded debt and no secured creditors. Its non-insider debt totaled approximately $816,000, more than half of which was owed to the debtor's landlord.
Lui, who managed the debtor's operations as CEO and sole director, stated that she filed a chapter 11 petition on the debtor's behalf due to chronic cash flow shortfalls, which Hu had refused to continue covering. Hu later testified that the refusal was based on Liu's mismanagement of the debtor.
In October 2023, Hu offered to serve as the stalking horse in a sale of substantially all of the debtor's assets in a transaction that would have permitted full payment of all non-insider creditor claims, but he was rebuffed by Liu.
In December 2023, the debtor proposed a chapter 11 plan under which Liu and Doody would receive 100% of the equity of the reorganized debtor in exchange for a "new value" contribution consisting of $100,000 in cash, waiver of Liu's claims against the estate, and a commitment by KJD to pay the debtor an annual management fee of $1 million ($500,000 less than the annual management fee payable under the ASA). The plan proposed to pay general unsecured creditors in full over five years, but without interest. It was not premised on any market test of the value of the debtor's assets to support the new value contribution.
The debtor later amended its plan to provide for payment of all general unsecured creditors in full on the effective date. The distributions were to be funded by invoking a provision in the debtor's operating agreement obligating GFG to make contributions on demand, which would have required Hu's consent. Both the original plan and the amended plan were unconfirmable for various reasons.
In March 2024, after the debtor's exclusivity expired:
- Hu filed a chapter 11 plan pursuant to which unsecured and administrative creditors would be paid in full on the effective date; the debtor's existing equity would be extinguished; the equity in the reorganized debtor would be given to a new company created by Hu, who would fund distributions under the plan and provide $5 million in working capital to the reorganized company; and the debtor would pay Doody $300,000 as part of a settlement in exchange for post-reorganization services; and
- Liu and Doody proposed a competing plan, under which the debtor's business would be sold at auction, but without a stalking horse; unsecured creditors would be paid in full with postpetition interest at 5.1% per annum; and the existing equity holders would receive $1 million, with distributions to be funded by Liu personally and a private investment firm.
On March 29, 2024, the bankruptcy court appointed a chapter 11 trustee for the debtor, finding Liu had grossly mismanaged the debtor and had irreconcilable conflicts of interest. The chapter 11 trustee supported Hu's chapter 11 plan.
Thus, the bankruptcy court was presented with competing chapter 11 plans.
The Bankruptcy Court's Ruling
The bankruptcy court confirmed Hu's chapter 11 plan.
U.S. Bankruptcy Judge Philip Bentley explained that Hu's plan satisfied all of the requirements for confirmation except section 1129(a)(8) of the Bankruptcy Code (all impaired classes have accepted the plan) because the class of interests to be extinguished under the plan was deemed to reject it under section 1126(g). Thus, he noted, Hu's plan could be confirmed only if the plan were "fair and equitable" and did not discriminate unfairly with respect to the dissenting impaired equity class, as required by section 1129(b)(1).
Judge Bentley rejected Liu's contention that Hu's plan discriminated unfairly by providing different treatment to the debtor's equity holders—Hu, Doody, and herself—because it proposed to give equity to Hu's new company, $300,000 to Doody, and nothing to Liu. According to the judge, section 1129(b)'s prohibition of unfair discrimination "applies only to discrimination between classes, not to discrimination among the members of a particular class." Global Fertility, 663 B.R. at 608 and n.10, n.14. In this case, Judge Bentley emphasized, Hu's plan did not discriminate unfairly among equity classes because there was only one equity class.
Liu argued that the treatment of equity under Hu's plan was not fair and equitable because it extinguished equity valued in her competing plan at $1 million—the amount to be distributed under her plan to equity—without any consideration. Hu countered that this argument was legally meritless because the fair and equitable test was satisfied—no class junior to equity would receive any distribution under his plan. Hu also claimed that the argument was factually inaccurate because the debtor's equity had no value.
Judge Bentley concluded that, although "the fair and equitable standard requires a determination whether the Debtor's equity has value," Liu failed to demonstrate that the equity in this case had any value. He accordingly ruled that Hu's plan was fair and equitable with respect to the impaired equity class. Id. at 608.
Judge Bentley rejected Hu's argument that when, as in this case, the debtor has only a single equity class, section 1129(b)(2)(C) by its express terms "compels the conclusion that such a plan is always fair and equitable" because the two prongs of the provision are stated in the alternative. Id. According to the judge, as indicated by the term "includes" in section 1129(b)(2), "the absolute priority rule is only part of the fair and equitable standard; it is not the entirety of that standard." Id. at 609.
The bankruptcy court explained that the language and legislative history of section 1129(b)(2) compel the conclusion that a cramdown chapter 11 plan that "extinguishes valuable equity for no consideration potentially violate[s] the fair and equitable test, even if the absolute priority rule is satisfied." Id.
According to Judge Bentley, section 1129(b)(2) of the Bankruptcy Code expressly defines part of the phrase "fair and equitable" as the absolute priority rule, but it does not set forth the entire definition, which Congress intended to be broad and flexible. This conclusion, he noted, is supported by the legislative history, which indicates that lawmakers intentionally omitted many of the factors interpreting the phrase both to avoid statutory complexity and recognizing that courts would readily recognize when a proposed treatment of an impaired class satisfies the standard. Id. (citing H.R. Rep. 95-595, at 549 (1978)). "A plan that extinguishes valuable equity for no consideration over the equity class's objection," Judge Bentley wrote, "is anything but fair and equitable, in the ordinary sense of those words." Id. at 611.
The bankruptcy court acknowledged that "[t]he case law addressing cramdown of equity is sparse" and that it was not aware of any decision from another court specifically addressing this issue. Id. at 610 n.17. However, Judge Bentley noted, courts that have examined an analogous issue—whether a chapter 11 plan can cram down equity while paying creditors more than the full amount of their claims—"have uniformly required the plan proponent to show that no such overpayment was involved, even when the plan satisfies § 1129(b)(2)(C)(ii)." Id. (citing and discussing cases).
The bankruptcy court also acknowledged that its interpretation could create "tension" between section 1129(b)(1) and the "more specific provisions of section 1129(b)(2)(C)(i) and (ii)," which, as noted, provide that a plan must either provide an interest holder with the value of its interest or provide that no junior interest holders will receive or retain any value. In particular, Judge Bentley explained, if the fair and equitable standard demanded that the proponent of any plan that extinguished equity prove that the extinguished equity was worthless, "this would be tantamount to requiring the plan to comply with subsection (i)'s fair value requirement regardless of whether the plan satisfied subsection (ii), thereby overriding section 1129(b)(2)(C)'s specific directive that a plan need only comply with one of these two subsections, not both." Id. According to Judge Bentley, this result would violate the established rule of statutory construction that a specific provision takes precedence over a more general provision.
With this tension in mind, the bankruptcy court adopted an approach that enforces section 1129(b)((2)(C)'s specific provisions, but construes them in a way that does not nullify section 1129(b)(1)'s fair and equitable requirement:
Thus, if a plan satisfies subsection (ii), the court must give effect to section 1129(b)(2)(C) by excusing compliance with subsection (i)—that is, relieving the plan proponent of the burden of presenting affirmative proof, let alone a formal valuation, showing that the equity has no value. However, if an objector presents evidence that the equity may have value, … section 1129(b)((2)(C) does not require the court to ignore the evidence. To the contrary, the court in that event must determine whether the objector has proved that the equity has value and, if so, whether the plan fails to satisfy the fair and equitable requirement as a result.
Id. According to Judge Bentley, this approach "harmonizes the conflicting statutory provisions by prohibiting a manifestly unfair outcome, while at the same time giving meaningful practical effect to section 1129(b)(2)(C)(ii)," a solution that is significant in light of the substantial burden and expense entailed by a bankruptcy valuation battle. Id.
However, the bankruptcy court found that Liu failed to establish that, despite the ascription of a $1 million value to the debtor's equity in her proposed chapter 11 plan, the equity had any value, either on a standalone basis or to a potential acquiror.
The court accordingly confirmed Hu's chapter 11 plan. In so ruling, the court noted that, although confirmation of Liu's alternative plan was not before it, Liu's plan was unlikely to satisfy the Bankruptcy Code's confirmation requirements: (i) given challenges to its feasibility, including unrealistic projections, and the uncertainty of the availability of money both to fund distributions under the plan and to provide extensive capital needed to get the debtor's operations up and running under new ownership; and (ii) because the plan proposed distributing new equity to insider creditors without paying unsecured creditors in full and without any market test of the value of the equity, the plan could not satisfy the "new value exception" to the absolute priority rule. Id. at 594 n. 5, 615 n.19.
Moreover, Judge Bentley emphasized, it was "curious" that Hu and Doody—who together held 85% of the debtor's equity—supported Hu's chapter 11 plan even though it extinguished their equity. He also noted that the potential for disruption to patient care, were Liu's plan to be confirmed, was significant, given the unwillingness of the existing medical staff to partner with the reorganized debtor under Liu's plan. Id. at 615–16.
Outlook
Global Fertility addresses an issue that has rarely been examined by other courts, and the bankruptcy court's decision is significant for a number of reasons. First, it illustrates the difficulties sometimes faced by courts asked to consider confirmation of competing chapter 11 plans, which include weighing the relative benefits of each plan for all stakeholders as well as analyzing each plan's fitness for confirmation according to the Bankruptcy Code's confirmation requirements. In Global Fertility, the court carefully analyzed the merits of both plans but readily determined that Hu's chapter 11 plan was clearly the better choice given the obvious deficiencies of Liu's competing plan. The decision might be more difficult in other cases.
Second, even though section 1129(b)(2)(C) would not appear to require such an analysis, the bankruptcy court concluded, based on its language, purpose, and legislative history, that when a chapter 11 plan extinguishes equity premised on the absence of any value remaining in the estate after the payment of creditors, a court should probe the accuracy of that premise to determine whether the proposed treatment of equity is "fair and equitable" for purposes of cramdown confirmation.
Finally, the decision reinforces the idea that a plan's treatment of a class of creditors or interest holders may not be "fair and equitable" even if it satisfies the absolute priority rule, as codified in section 1129(b)(2).
