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 Common stock not really used Bonds were predominate source Preferred Stock increased in use Individuals used it 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 Cumulative: 1. $ accumulates 2. If BOD declares dividend, no Common Stock can be paid a diviend until cumulative dividends are paid first Liquidation: Get liquidation preference, typically set at par Get cumulative dividends, before any common shareholder gets their interests Cannot demand dividend—as BOD Discretion Voting: Generally have no voting rights of Board Right of Election: May be in contract Typically: If fixed number of dividends are not paid (6), Preferred shareholders will get to elect a certain number of Directors Formation: 1. Articles of Incorporation From inception of corporation, articles of incorporation will have the preferred, the attributes 2. Amendment to the Articles of Incorporation If the AIC do not originally have the preferred shares, an amendment can occur with shareholders voting to include preferred 3. Board of Director Discretionary Provision Provision may exist that gives the BOD the discretion to issue a certain number of preferred shares Board will declare a resolution, file it with SOS, and this will amend the AIC Note on Negotiation: Preferred shares have similar attributes to debt in that the Contract Controls In Private negotiation: Similar negotiation of parties, that are sophisticated, to negotiate a package of preferred shares in each interests Courts will restrict to the contract In Public Offering: We see the same issues as public debt The erosion of the UW as protecting the interests for the same reasons, supra A. Cumulative and Non Cumulative Dividends and Voting Rights of Preferred Stock: Gutman v. Ill. R.R. 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