The Supreme Court will decide this fall whether secured creditors or owners of insolvent companies get the edge in corporate bankruptcies.
At issue is whether creditors must be repaid before equity holders, a basic tenet of bankruptcy codified by Congress in what is known as the absolute priority rule.
But that tenet has come under recent attack as courts have begun to apply the so-called "new value" exception, which allows equity holders to retain control of a business even if creditors are not fully repaid.
Michael F. Crotty, deputy general counsel for litigation at the American Bankers Association, said banks stand to lose millions of dollars a year if judges allow delinquent borrowers to erase debts simply by plowing more money into a business.
"There is no telling how much this case could be worth," he said. "There are more bankruptcies being filed now than at any time, even during the Great Depression."
The Supreme Court dispute pits Bank of America against 203 North LaSalle Street Partnership, an investment group that 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. The group declared bankruptcy and asked the court for permission to enter a Chapter 11 reorganization, which means the investors are given a chance to save the business instead of liquidating.
As part of its reorganization plan, the partnership proposed to repay the bank $54.5 million over five years-the assessed value of the 15 floors. To use the new value exception, the group also proposed investing an additional $4.1 million, which would be used to repay the bank about 16% of the loan's remaining balance. In exchange, the bank would write off the rest of the debt.
The court agreed to this plan, but the bank objected and asked a federal appeals court to void the deal. The bank said it wanted to immediately liquidate the property, believing it could recoup more from a quick sale than from giving the partnership five years to repay.
To support its appeal, Bank of America cited the absolute priority rule, arguing that it was inappropriate for investors to retain control when the bank was being forced to write off nearly $35 million.
The bank also asked the appeals court to rule that the new value exception-which was created by the courts, not Congress-was void. It argued that Congress never intended for investors in bankrupt companies to profit at the expense of secured lenders.
A sharply spilt federal appeals court in Chicago sided with the partnership, ruling that Congress implicitly endorsed the new value exception because it did not eliminate the rule when it reauthorized the bankruptcy code in 1978.
Bank of America appealed, saying the decision conflicts with rulings by federal appeals courts in New York and Richmond, which have eliminated the new value exception.
A Bank of America spokesman said the case is important for all corporate creditors.
"We are critical of the new value exception because it enables business owners to exercise control over reorganizations even when their equity holdings are worthless," the spokesman said. "Moreover, there is no evidence that Congress intended that there be such an exception to upset the careful balancing of the rights of creditors and debtors in the bankruptcy code."
The spokesman also warned that the decision, if not overturned, could discourage some lenders from the business credit market.
"The absolute priority rule is an important consideration in lending decisions," the spokesman said. "Any exception that undermines it necessarily affects the willingness of lenders to extend credit."
The justices are expected to hear the case in October and issue a decision in December.