Corporate Finance Outline – Mitchell – Spring 2011 I. Limited Liability’s Effect on Corporate Finance


I: Was this Reorganization plan Fair, Equitable and Feasible? R



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I: Was this Reorganization plan Fair, Equitable and Feasible?

  • R:

  • 1. The Cram down and Absolute Priority Rule:

    • 1. The Reorganization agreement must be Fair, Equitable, and Feasible—Met If:

    • When Agreement:

      • When negotiated for agreement, what claimants agree to is accepted

    • When Disagreement/Dissenting Party:

      • Cram-Down Rule:

        • Courts will “cram down the throats of creditors” an agreement if

          • (1) They are paid the full value of their claim or if not repaid in full

          • (2) The Absolute Priority Rule:

            • If no junior claimant receives anything at all on account of their junior status

            • Every cent owed is paid before any cent is given to junior claim

      • Reason:

        • 1. Fulfills Absolute Priority Rule

          • Is fair, and equitable

        • 2. Prevent Opportunistic Holdout

          • Avoids holding out by creditors, to get purely opportunistic behavior of more $ for them

          • Prevents “feasibility” from being negated—otherwise, if creditors could hold out, the plan may then not be feasible, may lead to liquidation which is not the most desired result

        • 3. Promotes Social Interest and Broad Concerns of Bankruptcy:

          • 1. People lose their jobs, suppliers go bankrupt, customers are effected

            • Feasibility is broadly interested in continued going concern

      • Hierarchy:

        • Debt (in order of seniority)

        • Preferred Shareholders

        • Shareholders

      • Value Received:

        • Creditors must get their “superior rights recognized”

        • (1) They can get their full value back, of exactly what they were owed

          • OR

        • (2) Get less back with additional, alternative compensation, for the rights they surrendered

          • As long as they are still, net, at their superior level, APR met

        • Determination by Judge:

          • Case by case analysis to determine if they were fully compensated

      • Reason for APR:

        • This is what they contracted for

        • So, Court is merely giving them what the contract stands for

        • In Limited Liability structure, they gave up control, and locked in risk, so they would have priority at bankruptcy




          • 2. To Determine Fairness, Equity, Feasibility of Reorganization Plan, Valuation of Company As Going Concern Must Occur:

            • Must Value the Corporation as a Going Concern:

              • (1) The assets the are continuing

                • Must determine what assets exist, and will be used as part of the going concern for feasibility of continued existence

              • (2) Going concern and capitalized future earnings of company

                • Valuation:

                  • Capitalized Earnings of Future Earnings is required to determine Feasibility and Fairness

                    • Reason:

                    • That is the only way can determine if fair to new security holders and if the company can feasibly pay them back

                    • Only way to ensure absolute priority rule is met

                  • Book Value, of Physical assets, without regard to earning capacity is inadequate

            • Why:

              • 1. Determines if fair, and absolute priority rule met

              • 2. Only way to determine if what is given for exchange is fair and correctly valued

                • If valuation done is not correct, there is a chance that creditors are given inadequate value (and not fully compensated)

                • The effect would be to give them less then full value, and if junior claimants receive something—violate the absolute priority rule

              • 3. Only way to determine feasibility of corporate continued viability

          • Here:

            • Bondholders treated identically, although both had different claims

            • Inadequate valuation occurred of the new company—leading to inability to judge fairness and feasibility of the reorganization plan

            • Absolute Priority Rule Violated:

              • Inadequate Valuation

              • Bondholders given less than full value without additional compensation

              • Shareholders, junior claimant, given piece—junior claimants

                • Violates APR

                • Not Fair or Feasible




      • 3. The New Value Exception to the Absolute Priority Rule:

        • Generally:

          • In the event that a dissenting creditor exists, an agreement may be forced upon them if the cram-down rule is met

          • The “New Value” exception is a rule that may, if it exists, allow for the absolute priority rule to not be met

            • So, junior claimant can get value of firm even if senior claimant hasn’t been fully compensated

          • No clear answer

          • The New Value Exception:

            • Investors who put up new capital for interest in firm equal to new contribution

            • Consideration is “money or money’s worth”

              • Reason:

                • This still fulfills the absolute priority rule, as no claim junior to creditors is received from company, but instead is new value added

                • There is argument over what “on account of means” in the BOA case, but Supreme Court has not decisively ruled

        • Kham & Nate’s Shoes v. First Bank:

          • F: Bank had been lending money to Kham store to buy goods. The loan was secured by supplier’s goods. Issues arose, and debtor store could not repay. Bank lent it a line of credit, and then default occurred. Overall, total debt owed was 42,000 loan+47,000 letters of credit + 75K Line of Credit=164.

          • PH: The lower court allowed a “new value” exception, because the stockholders “guaranteed” debt repaid.

          • I: What is the significance of the new value exception?

          • R:

            • 1. The Cram-Down Rule must be met if Creditors do not approve plan

              • However here

                • Class of unsecured, subordinated creditors are getting property—the option to buy the property, the stock—while senior claimants are not fully compensated, and junior claimant is getting something

                  • Violates the Absolute Priority Rule

            • 2. The New Value Exception

              • Purpose:

                • Makes sense as some firms depend on success of the entrepreneurial skills or special knowledge of managers

                • If they contribute new vale to retain interest, may benefit firm feasibility and future viability

                • In Creditor’s interest to have managers with this experience

              • Genesis:

                • Case v. Los Angeles

                  • Shareholders may retain interest for money or money’s worth

                  • Non-monetary value insufficient

                • Bankruptcy Code of 1978

                  • Did not specifically include it, and legislative history didn’t include it

                  • While some believe the rule didn’t survive the new code, court doesn’t rule on this

              • Consideration that is “money or money’s worth”:

                • May acquire interest equal to, or less than consideration given

                • What does not suffice:

                  • Promise of labor, experience,

                  • Intangible, unenforceable items that have no place in balance sheet

                  • Guarantees

                    • Are not enforceable, and not certain

                • What may suffice:

                  • Balance sheet asset

                  • $ and some intangible item like promise, labor, etc…

            • 3. State law survives Bankruptcy and Supplements Throughout

              • Generally:

                • In addition to the Federal Bankruptcy Structure, state law must be complied with

              • Here:

                • Consideration of guarantee, per state law, would not have been sufficient to buy stock

                • Therefore, Guarantee is not sufficient to meet New Value Exception

        • Bank of America v. 203 N. Lasalle St. Partnership (US):

          • F: Bank lent the partnership some $93M, secured by 15 stories of a building in Chicago. Default occurred, and foreclosure ensued. To avoid personal tax liabilities, due to pass-through taxation, partnership partners wanted to keep title. The value of the mortgaged property was less than mortgage. Assets available were $54.5M, but owed $93M, leaving 38.5M remaining. In the reorganization plan, among repayments, the partners would pay $6.125M over 5 years to retain full ownership of property.

          • PH: The bank objected to their plan, arguing that cramdown had not been met.

          • I: Does the New Value Exception still apply?

          • R:

            • 1. The Court does not rule, but assumes the exception exists:

              • Interprets “on account of” in the cram-down language of statute 1129

                • “if the holder of claim that is junior will not receive or retain under the plan on the account of such junior claim

              • Does not rule

            • 2.Otherwise cognizable property interests are treated as valuable for recognition for Bankruptcy Purposes

              • The option to partnership equity and title is property

              • The opportunity the partners got this property from is based on its old interest

                • Therefore: they got this “on account of” their old position

                • Violate the Absolute Priority Rule, as lesser claimant is getting something while dissenting Creditor is not fully compensated

            • 3. Market Valuation of Equity

              • Court advocates that the equity should be subject to a market test, requiring offering of competing plans

              • Valuation Issue:

                • Because it was exclusive right, and offer, value may be off

                • May not have been top dollar for the equity interest

              • Should subject equity to a market valuation

              • Assuming the new value exception, plans that provide junior interests exclusive opportunity, free from competition, without benefit of market valuation do not meet 1129 Absolute Priority Rule

                • Effect:

                  • May force parties to put interest on open market

                  • Payment for the position may be much higher

                  • Huge $ for position, but may be more in line with bankruptcy law of fair and equitable as creditors thus have more compensation

                  • May force parties to negotiate the deal up front to avoid exposure to market and increased cost




        • Modern “New Value Exception”

          • Some Circuits accept it

          • Supreme Court has not explicitly accepted it, but “assumed” its existence and continued vitality

          • Of those that do continue to recognize it:

            • Requires at least equal consideration as to interest received

            • May require “substantial” consideration, especially in light of BOA




      • 4. “Pre-Package” Plans of Reorganization” for Chapter 11:

        • Generally:

          • The plan will be negotiated by Board of Directors with creditors and interested parties before bankruptcy is filed

          • Purpose:

            • Get through Chapter 11 as quickly and easily as possible

            • By getting agreement before hand, and quick court assessment

              • Continue Process

              • Less time hurting stakeholders

              • Feasibility of company is more quickly realized

                • No costly litigation, complaints, or judicial inquires

        • Fiduciary Duty still owed to shareholders:

          • Because this plan is pre-bankruptcy

            • Fiduciary Duty still owed to act fairly in shareholders best interest

            • Revlon duty to maximize best price of deal exists

          • Post-Bankruptcy

            • Fiduciary Duty owed and enforceable to creditors

        • In Re Zenith Corporation:

          • F: Zenith had losses in 12 of 13 years. LG was a dual creditor and controlling shareholder. It attempted to attract bids, and sell assets to no avail. Finally entered into a pre-package deal with LG, to restructure debt and equity. Disclosure was made, approved by SEC, and distributed. 97% approved. Zenith filed the pre-package plan, and sought approval.

          • I: Was the pre-package plan adequate?

          • R:

            • 1. Disclosure:

              • If Chapter 11 filing Court must approve disclosure before made

              • If Pre-Package it is acceptable if it complies with non-bankruptcy law or had adequate information

              • Here:

                • Proxy was approved by the SEC and was adequate

            • 2. Cram down Rule:

              • Shareholders object to plan, arguing it is not fair or equitable

              • Here:

                • Crammed down because no junior claimant to shareholder gets anything

                • Cramed down because they get their fair value  nothing

            • 3. Agreement existed:

              • Agreements are beneficial

                • Avoid cram-down fights

                • Within the purpose of the bankruptcy code of “Fair and Equitable” if they agree

              • Cram Down is not needed if there is an agreement and it is accepted by vote

            • 4. North Lasalle Does not Apply:

              • LG is a creditor at bankruptcy, and is getting equity by agreement

              • In N. Lasalle, shareholders kept in their own plan, exclusive right to equity, without giving creditors right or market ability to bid and creditors disagreed

                • Violated the Absolute Priority Rule, as creditors were not fully compensated

            • 2 Potential Equity Claims:

              • Disallowance of Creditor Claim:

                • A claim will be disallowed if it has no legitimate basis for it

              • Recharacterization or Equitable Subordination

                • A claim will be recharacterized or subordinated if inequity is done

                  • See Pepper v. Litton



            • State Law must by Complied with During Bankruptcy Proceedings:

              • Delaware “Entire Fairness Test”

                • A transaction with a company and a controlling shareholder must be entirely fair

                  • Fair price and process

                  • Here was fair:

                    • Using bankruptcy code is acceptable

                    • Committees were made to determine value

                    • Attempts to sell were made

                    • Price was fair as LG was relinquishing greater amount of debt for all stock in company

                    • No other suitor could be found

            • Effect of Dual Shareholder and Creditor:

              • Fact Specific Inquiry to determine which claim is really being compensated for

                • May be an issue:

                  • If acting like shareholder, would violate Absolute Priority Rule

                  • Obviously in their interest to act as debtor at bankruptcy

                • Look at:

                  • Do they have more debt than equity?

                  • Act more like creditor than shareholder?

                • Note the Controlling Shareholder Fiduciary Duty owed

    V. Preferred Stock:

    • General History and Attributes:

      • History:

        • In late 1800s, railroad activity began to increase and needed method of financing

          • 1. Debt was heavily relied on (See supra)

            • Investment banks attracted European investors to buy the debt

            • Secured, so they were safer in their investment

            • However:

              • Fixed costs of railroad combined with fixed cost of interest payments were increasing as Railroads expanded rapidly

              • Needed lots of $ all the time, as growth was explosive

              • Increased debt was not option

                • Would increase fixed costs

              • Equity was not an option

                • Were not many public companies

                • Not many individuals bought it and institutions in Europe wanted safe investments

                • When did exist, families held it, to hold control

          • 2. Retained Earnings

            • Have historically been a method of financing

            • But railroads didn’t really have them

        • Preferred Stock Born:

          • Combined safety, risk averseness of European investors with a higher rate of return then debt

          • As a result of

            • M&A boom in 1890s-1900s created need for some alternative financing

            • Railroad need of financing

          • Early 1900s

        • Post-Crash of 1929:

          • Many Bankruptcies

            • Debt default and

            • Preferred Stock arrears

          • Courts role in its deterioration

            • In desire to allow businesses to continue, the importance of debt to the capital markets—didn’t want to impair debt as main source of financing

            • Courts began to dump on Preferred Stock

              • This is where we see the erosion and formation of its attributes

        • 1940s and 50s:

          • Institutional investors began to buy it as a result of the ORP standard some states required of them

            • Because no ORPs were buying common stock, as a result of the crash, ORP bought preferred

          • This is where Institutional Investors began to buy Preferred

        • Modernly:

          • Preferred is predominately owned by Institutional Investors

      • Attributes:

        • Generally:

        • A Hybrid of Debt and Equity

          • At Bankruptcy:

            • Junior to Debt

            • Senior to Common Stock

          • Dividends:

            • Only paid at the discretion of the board declaration

            • Non-Cumulative: If not paid, no accumulation, expire—lose them if unpaid



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