Though the banking industry won a recent bankruptcy case before the Supreme Court, legal experts are divided on whether the decision will do much to help lenders.
The justices ruled that lower courts erred in allowing owners of a bankrupt real estate development to retain their equity stake in the project while some creditors went unpaid.
The ruling was widely hailed as a victory for creditors, because it appeared to fortify the so-called absolute priority rule. That rule, a basic tenet of bankruptcy, states that creditors must be repaid before equity holders.
That tenet, however, has been eroded in recent years as judges have created the so-called new-value exception to the absolute priority rule. This exception allows equity holders to invest new money in a project without losing their ownership stake, even if some creditors are not fully compensated.
The case centers on a fight between Bank of America and the 203 North LaSalle Street Partnership, which borrowed $93 million to buy 15 floors of a Chicago office building. The loan was due in January 1995, but the partnership was unable to pay and declared bankruptcy.
As part of its reorganization plan, the partnership agreed to repay Bank of America $54.5 million, which was the assessed value of the 15 floors. The investors also proposed to raise more than $4 million to repay 16% of the rest of the loan. The bank would be forced to write off the remaining $35 million of debt.
Bank of America objected, asking a judge to void the plan and give it permission to liquidate the property. As support, it cited the absolute priority rule.
The lower courts rejected Bank of America's petition, but the Supreme Court disagreed. It said the lower courts were wrong to give equity holders the exclusive opportunity to retain the property in exchange for new cash. Instead, it should have invited competing bids, including one from the lenders.
Bankruptcy experts are divided on the significance of the decision.
"This is not a big win for creditors," said Madlyn Gleich Primoff, a partner in the New York office of the Battle Fowler law firm. Rather than rejecting the new value exception, the justices simply imposed a few hurdles debtors must cross, she said.
Ms. Primoff also questioned why anyone other than the equity holders would bid on these properties, which almost always have a negative net worth. "If there was equity in the project, the partnership would refinance the debt," she said. "But these are situations where the property is worth less than the debt."
David R. Kuney, a partner in the Washington office of Womble, Carlyle, Sandridge & Rice, said nothing in the decision would require a judge to select the lender's plan rather than the equity holders' proposal. "The court could consider both options and might well support the equity holders' plan," he said.
The real impact will be in negotiations between debtors and creditors, he said. "This will force consensual resolutions," he said. "Both sides are now a little more at risk. It may lead to both parties hammering out a consensual approach."
Yet Roy T. Englert Jr., a partner in the Washington office of Mayer, Brown & Pratt, who represented Bank of America in the case, said opening up the bidding on these properties is essential.
"There may be other people who are willing to pay more for the equity," he said. "The bank may think the building is worth more and bid up the price."
The ruling also will make lending to marginal borrowers safer, because banks are more likely to recover their investment if the debtor goes bankrupt, he said.
"This negates a device that equity holders in bankrupt estates were using to deprive lenders of what they were entitled to in bankruptcy," he said. "It means lenders will come out ahead in bankruptcy."
The end result of these disagreements, lawyers said, will be more litigation and a likely replay before the Supreme Court.
