US Bankruptcy Court establishes guidelines for “new value” plans of reorganization in competing plan scenarios

Introduction

On October 25, 2024, Judge John P. Mastando III of the US Bankruptcy Court for the Southern District of New York issued a ruling in Eletson Holdings Inc., Case No. 23-10322, pursuant to which he (a) denied confirmation of the debtors’ plan of reorganization because it violated the absolute priority rule and (b) held that the new value exception to the absolute priority rule – that would have enabled the debtors’ existing shareholders to fund and retain their equity in the reorganized debtor – did not apply.

Judge Mastando found that the debtors’ plan could not meet the new value exception, particularly in the face of a competing confirmable creditor plan that provided a greater and more certain recovery to creditors. In so doing, Judge Mastando harmonized seminal Supreme Court and Second Circuit precedent and articulated a framework for other courts to use when faced with the new value exception.

Background

Eletson Holdings Inc. and its affiliated debtors (collectively, the Debtors) are part of Eletson Enterprise, an international gas shipping company which owned and operated a fleet of gas tanker ships.

In early 2019, the Debtors defaulted under indentures, prompting negotiations with noteholders that culminated in out-of-court restructuring support agreements. Following the Debtors’ breach of those agreements, Murchinson Ltd., an alternative management firm for institutional investors (with its affiliated entities, collectively, the Murchinson Entities), acquired a majority of issued notes. On March 7, 2023, the Murchinson entities led the filing of an involuntary chapter 7 bankruptcy petition against the Debtors. On September 6, 2023, the Debtors and the Murchinson Entities stipulated to convert the involuntary chapter 7 case to one under chapter 11.

The chapter 11 case and the three competing plans of reorganization

On January 23, 2024, the Debtors filed their first plan of reorganization on the last day before the expiration of their statutory 120-day exclusive period to file that plan. The Debtors’ exclusive right to propose a plan terminated when the Debtors could not obtain timely creditor acceptance of that plan. Thereafter, certain creditors, including the Murchinson Entities (collectively, the Petitioning Creditors), and the Debtors submitted three separate competing plans of reorganization.

The Debtors’ plan constituted a so-called “new value plan” that contemplated issuance of 100 percent of the equity of the reorganized Debtor to the Debtors’ pre-bankruptcy shareholders (the Debtor Plan). In exchange, those pre-bankruptcy shareholders would contribute $37 million to fund the Debtor Plan. In addition, the Debtor Plan proposed the distribution to creditors of a percentage of proceeds arising out of a contemplated but not-yet-final award resulting from the Debtors’ pending but unresolved arbitration dispute with the Murchinson Entities over ownership of existing preferred shares (the Collections Contribution). To substantiate the Collections Contribution, the Debtors also provided a guarantee of $40 million dollars to be paid in monthly installments of $1 million beginning on the effective date of the Debtor Plan.

On the other hand, the Petitioning Creditors proposed two plans of reorganization. The first plan was closely modeled after the Debtor Plan, except that it offered $41 million in exchange for the equity in the reorganized Debtors instead of the $37 million offered by the pre-bankruptcy shareholders in the Debtor Plan (the PC Alternative Plan). The Petitioning Creditors also escrowed $43.5 million to provide assurance of performance under the PC Alternative Plan. In addition, the Petitioning Creditors agreed to contribute “contingent value rights” to a litigation trust representing distributions from the Collections Contribution.

The second plan the Petitioning Creditors proposed would be funded by $53.5 million in equity rights, offering holders of general unsecured claims with subscription rights to purchase up to 75 percent of the equity of the reorganized debtor (the PC Plan). In addition, as set forth above in connection with the PC Alternative Plan, the Petitioning Creditors escrowed $43.5 million and one of the Murchinson Entities backstopped $53.5 million to guarantee performance under the PC Plan.

The Debtors and Petitioning Creditors jointly solicited their plans. The solicitation process provided impaired creditors with the right to vote on more than one plan and indicate their preference by ranking the respective plans. Ultimately, the PC Plan received the majority of votes from the impaired classes of claims.

Prior to the confirmation hearing, both the Petitioning Creditors and the Debtors filed objections to the others’ plans. The Petitioning Creditors argued that the Debtor Plan violated the absolute priority rule and could not rely on the new value exception.

The absolute priority rule and new value exception

Bankruptcy Code Section 1129(b)(2)(B)(ii) sets forth the priority waterfall for recoveries in a chapter 11 plan. Pursuant to this so-called “absolute priority rule,” a plan must pay unsecured creditors in full before any stockholder retains or receives property under the plan (unless the unsecured creditors otherwise consent to the stockholder recovery). It is well established that a shareholder’s right to fund a plan and obtain equity of a reorganized debtor constitutes the retention of a shareholder property right that must be evaluated under the absolute priority rule.

However, case law from the Supreme Court and the Second Circuit created an exception to the absolute priority rule where equity holders may retain their equity in the debtor even where the plan does not provide for payment in full to creditors. This exception is referred to as the “new value exception” or “new value corollary” to the absolute priority rule. The Supreme Court and Second Circuit established five requirements for satisfying the new value exception: The capital contribution by old equity must be (1) new, (2) substantial, (3) money or money's worth, (4) necessary for a successful reorganization, and (5) reasonably equivalent to the property that old equity is retaining or receiving.

The new value contribution was not “new” and other portions were not “money or money’s worth”

Judge Mastando noted that in order for a contribution to be “new,” it must originate from outside a debtor’s business or come from a source “to which the debtor is not already entitled.” In addition, in order for a contribution to be considered “money or money’s worth,” Judge Mastando emphasized, it must be a “present (emphasis added) contribution by the shareholders” and not a promise of future services or payment.

Judge Mastando held that although the Debtor Plan’s $37 million cash contribution did satisfy the “new” and “money or money’s worth” prong, the Collections Contribution failed to satisfy both of these prongs. Specifically, Judge Mastando found that the Collections Contributions were not “new” because the Debtors owned 100 percent of the common shares of the entity providing the funds under the Collections Contribution, and therefore, the contribution would be coming from inside the Debtors’ capital structure. As a result, the Debtors, and consequently the creditors, would already be entitled to the Collections Contribution.

In addition, Judge Mastando held that the Collections Contribution did not constitute “money’s worth” because the Collections Contribution was speculative and contingent. In particular, as of the confirmation hearing, the Debtor could not confirm when the arbitration would be subject to a final award, and whether, and in what amount, the Debtor would collect on that award. Although the Debtors guaranteed $40 million of the Collections Contribution, Judge Mastando held that the Debtors failed to provide sufficient evidence that the guaranteed funds would actually be available for distribution to the Debtors’ creditors.

The new value contribution was not “substantial”

Judge Mastando observed that, to satisfy the “substantial” prong of the new value exception, a court must weigh the new value against the claims being disposed of by the plan. The Debtor Plan only provided $37 million in new value, which represented a recovery against general unsecured claims of approximately 7.3 percent (ie, $505 million of claims divided by $37 million). Judge Mastando relied on case law, holding that recoveries of up to 7.5 percent did not qualify as “substantial.” Notably, Judge Mastando cited a case from the Bankruptcy District of Delaware, finding that a recovery of 15.9 percent met the substantial standard.

The new value contribution was not reasonably equivalent to the value of the reorganized debtors

The Second Circuit requires a debtor to market-test the value of the equity purchased to demonstrate that the new value contribution is reasonably equivalent to the market standard. Judge Mastando emphasized that the prong is not satisfied where the new value contributed is “grossly disproportionate to the value of a debtor’s equity or assets.”

Judge Mastando noted that the Debtors relied solely on the termination of exclusivity and the competing plan process to “market test” the Debtor Plan instead of contacting a wide range of potentially interested parties, making diligence information available to prospective bidders, executing non-disclosure agreements, or hiring investment bankers or other advisors to run a market process. Judge Mastando expressed some reservations as to whether a competing plan process would be sufficient to market test a plan, but held that, regardless, the Debtors could not meet the reasonably equivalent value standard because (a) the Debtors valued the reorganized equity at approximately $84.3 million, which was more than double the $37 million contributed by the Debtors’ stockholders, and (b) the PC Plan contemplated the purchase of the Debtors’ equity by the PC Plan proponents at an implied valuation that exceeded the Debtors’ new value by more than $16.5 million.

The new value contribution was not necessary

Finally, Judge Mastando explained that in order for the new value contribution to be necessary, the “debtor must show not only that it needs funds to reorganize but that it is necessary for old equity (emphasis added) to contribute these funds.” According to Judge Mastando, the existence of the PC Plan demonstrated that new value from the old equity was not necessary.

The Debtors argued that they would be contributing more overall value to creditors when considering all components of funding in the Debtor Plan. Judge Mastando rejected this argument and found that the PC Plan provided “higher day-one distributions to creditors than the Debtor Plan, rendering the Shareholder New Value Contribution unnecessary.” He also noted that he was unaware of any recent cases in which a court confirmed a new value plan in the face of a confirmable competing plan filed by a debtor’s creditors, particularly where, as here, the creditors were willing to contribute more new capital than the Debtors.

The Debtor Plan is not feasible

Even if the Debtors had satisfied the new value exception, Judge Mastando would not have confirmed the Debtor Plan. Judge Mastando found that the Debtor Plan could not satisfy the “feasibility” confirmation requirement, ie, that the Debtors did not demonstrate that the Debtor Plan was not likely to be followed by another reorganization or liquidation. According to Judge Mastando, the Debtor Plan lacked sufficient day-one funding, a reliable commitment letter with respect to the new value contribution, and an adequately funded litigation trust.

Instead, Judge Mastando entered an order confirming the PC Plan.

Key takeaways of Eletson Holdings Inc.

The Eletson case provides several key takeaways to consider when structuring a new value plan:

• Any new value contributions must come from sources other than the debtor or its controlled subsidiaries.


• New value should be in cash or cash equivalents available on the effective date of a plan. If payments are to be made in installments, they should be placed in escrow to ensure availability.


• The Debtors’ value should undergo market testing to meet the standards of reasonable value and necessity, and not rely solely on the termination of exclusivity.


• A new value contribution below 7.3 percent of creditor claims will fail the “substantial test” for new value plans. However, there is an open question as to whether contributions that fall between 7.3 percent and 15.9 percent satisfy the substantiality requirement.

For more information

If you have any questions about this ruling or any restructuring-related matter, please reach out to the authors, Robert Klyman and Shant Eulmessekian, or your usual DLA Piper contact.