Caesars, Asset Stripping Allegations, and Absolute vs Relative Priority

FT Alphaville, a feature at ft.com, put up an amazingly thorough post (may be gated but you can register and read it for free) yesterday (12/18) on the current restructuring and related lawsuits brought by bondholders of Caesars Entertainment Operating Company, a slighltly-less-than-wholly-owned subsidiary of publicly traded Caesars Entertainment Corporation.  Cleverly, it's called "Et tu Caesars".  The article gives you org charts, stock price charts, recovery estimates from the rating agency Fitch's, links to the four complaints, a 475-slide powerpoint prepared by Blackstone that appears to be the basis of discussing restructuring with the first lien, and walks the reader through the significance of all these materials in admirably efficient fashion.  The graphics are too much for me to cut and paste the article in here, so I will provide a brief summary of what the dispute centers on:

Recall the two companies mentioned above, CEC and CEOC.  When the LBO was done back in pre-crisis times, CEC owned 100% of CEOC.  CEOC issued the bonds that the plaintiffs hold.  CEC gave a parent guarantee of those bonds.  Pretty normal stuff. 

Then, post-financial crisis, the outlook for the owners ever getting a return on their money became bleaker.  Creatively (other words are used as descriptions), a plan was hatched and in fact executed to transfer eight valuable properties from CEOC (bond issuer subsidiary) to CEC (parent guarantor).  So what, one might ask, if they're both liable for the debt?  Well, that is where creativity (or alternative term  -- the complaint uses words like "rob" "Steal" "plunder" and "pillage") hit a new height.  I'll quote from the FT Alphaville post:

"The second step is to terminate the obligation of the parent to make good on the debt.
CEC attempted to terminate the guarantee by selling a 5 per cent stake in CEOC for $6.15m which, according to the indentures, releases the guarantee because it is no longer wholly-owed by CEOC. Note the apparent absurdity in selling a stake that values CEOC equity at $120m when it holds $18bn in total debt.

"As was reported in May, the guarantee release is provocative because of nebulous wording in the debt documents ...."

"But it gets more complicated. As it turns out, at the same time of the CEOC equity sale, CEOC sold $1.75bn in first-lien term loans (B-7 tranche) that did come with an amended parent guarantee for the B-7 term loan along with other existing term loan holders who agreed to certain concessions.
And just who bought the fateful stake in the seemingly worthless CEOC equity that triggered the release of the parent guarantee? According to a Debtwire article cited in the first-lien complaint it is the hedge funds who simultaneously bought the B-7 bank debt."

In addition, assets were transferred from CEOC (again the bond issuer) to additonal affiliates at least one of which, Caesars Acquisition, is outside the CEC family altogether, but is partly owned by the same shareholders (Apollo, TPG and others) who own CEC. 

This is very hard ball, and certainly provides good, lively and I imagine lucrative employment for lawyers in an otherwise sluggish restructuring activity.

I do encourage the reader to visit the FT site, and read the post. It's very well done (for anyone let alone a journalist). 

I only have one comment to add to it, apropos of the theme I have been developing in recent posts.  How you react to the shareholders' actions here should be consistent with how you come down on the issue of absolute priority vs. relative priority that has surfaced, once again, in bankruptcy policy debates.  What the shareholders have done, economically, whether or not contractually permitted, is simply take some, but not all, of the debtor CEOC's assets away from the creditors who relied on them when credit was first extended, for themselves, leaving the creditors with a diminished return, effectively mitigating the $6B in losses the shareholders would otherwise suffer upon a strict application of absolute priority by spreading about $2B of that loss around among the CEOC  bondholders, who stand to receive, subject to further negotiation or litigation, around 70% of their claim, if I read the Fitch's material correctly. 

This is in form and principle, if not in amount, exactly what some recent proposals and arguments have contended should become the norm in chapter 11 reorganization plans, a further evisceration of the absolute priority rule to one in which an out of the money class, which could be pre-petition equity, receives value out of the recoveries that would otherwise belong to the senior creditors.  I won't repeat the arguments or my views on them again here.  I only want to connect the dots between this currently-out-of-bankruptcy-but-not-for-long situation and the broader absolute priority debate for now.  Because the holidays are coming and it's time for a little break!

Normalization with Cuba: The Regime Runs Out of Options; Obama Runs Out of Elections

I was thrilled to hear the news today that President Obama has set the nation on a path toward normalization of diplomatic relations with Cuba.  I think that is clearly in the best interests of the United States in the long-term.  Since I visited Havana back in October,  one thing that stuck in my head was the statement of the #2 guy at the U.S. Interests section (the "don't call it an embassy" that is nevertheless the largest diplomatic delegation in Cuba) that "you won't find a more pro-American population on the face of this planet than the Cuban people."  That made huge sense to me.  I think the best way to create people deeply committed to traditional American values is to expose them to decades of socialist repression.   Watching CNN en español this afternoon, they were reporting widespread celebration and jubilation among the people in Havana.  Obviously many people have relatives in the US and this will facilitate family connections, but I would bet that even among those who don't see it through a family prism, they see this as a step toward a better economy and polity.

One of the news angles on this story is that the Pope somehow played a major role in this breakthrough. I discount that quite a bit. I think it is one of those cover stories that smart diplomats and spin masters come up with and they deserve credit for so doing.   I think playing up that angle, because of the Pope's relatively high popularity, is just "spin", an attempt by the White House to position the controversial step in a way that borrows some of the Pope's popularity and moral standing. 

But the truth is the State Department has been hoping for this probably the last 40 years.  And Obama has wanted to do this since taking office.  He just couldn't go too far until all the Florida elections of his term were behind him.  And the last one (Florida gubernatorial, where his supporter Charlie Crist was in a close race throughout) passed last month.  And as for Cuba, the collapse of their last economic lifeline,  Venezuela  --  which has been sending them $8-9 billion a year since Chavez took over, plus providing other support like hooking them up to the Internet etc  -- put the regime in a desperate situation where their only hope of avoiding economic collapse and a return to the starvation of the 90's was to reach out to their gigantic, wealthy neighbor 90 miles to the north.  In short, Obama ran out of elections and the Castros ran out of options.   Those are the "realpolitik" facts.  

I don't see this as a concession by Obama as the GOP and certain Democrats claim.  I think it is more a capitulation by the Cuban regime.  The first of many I hope, although the cynic in me suspects the likely scenario over the next decade will involve, like China, like Egypt and probably a few more nations, modest liberalization and gains in welfare for the average citizen, and large increases in wealth for the higher-ups in the regime, particularly the military, because that's how they get bought off not to launch a coup and take power themselves.  When I was down there in October, we drove past a hotel being constructed and were told the military's construction arm was building it, and I thought, "I've seen this movie before."

Speaking of making money, normalization makes so much sense for American business interests.  When we were there, we were told that the Chamber of Commerce of one of the midwestern states had sent hundreds of people there in several delegations this year. I think it was Iowa.  Right now, due to the embargo, it's hard to travel, the major airlines don't fly there; you can't get use your regular cellphone network, or your American credit card or travelers' checks.  The hotels we stayed in were managed by European companies.  The buses we rode on were Chinese.  There are dozens of dilapidated buildings falling down and crumbling with breathtaking ocean views. There is a lot of money to be made.  Ironically, the big loser when Havana comes fully online for tourists will be Puerto Rico -- I was in both San Juan and Havana this year and I would take Havana for a week of tourism in a heartbeat.

Republicans are expressing outrage which is what people in opposition do.  But I find the arguments impractical, emotion-driven or too blatantly political to get in the way of the nation's self-interest. 

  

Impractical:  The U.S. embargo -- which was initially an executive order but was hardened into statutory law during both the Clinton and Bush 43 administrations, and thus cannot be lifted unilaterally by Obama -- is at best a symbolic gesture of solidarity to the victims of Castro's takeover.  It is at worst an unintended prop for the Cuban government remaining in power, in that it provides them an external scapegoat for all the shortfalls of the Cuban economy.  In no meaningful way is it effective, if the test of effectiveness is its original  goal of bringing about regime change in Cuba through non-violent means (I am not sure what other goal it would be measured by).  The Castros have run the country for nearly 56 years now.  Whatever problems the embargo caused decades ago, workarounds of one sort or another have been developed and loopholes have arisen to the point that the embargo, however solemn its rationale, is in practice, something between an irritant and a joke.  Cuban officials and their state-controlled press call the embargo "genocidal" which is a tragically absurd abuse of the term, and laughable given the loopholes and workarounds that render it largely ineffective. I mean, I couldn't buy Coke or Pepsi in Havana but I could buy Red Bull.  I couldn't fly a scheduled US airline in there, but charter companies could sub-lease American or Jet Blue planes and fly them in. Seriously, it's just not doing much anymore except cutting US businesses out of opportunities for which they are logical partners, and giving the regime an excuse for its own economic failures.

Likewise there were some today saying, "Good luck getting an embassy funded."  Again, there has been a de facto embassy in Havana for decades and it has been funded without, AFAIK, any real rancor.  Changing the name of what you've funded does not strike me as a rational basis to depart from prior practice (although I recognize the political theater of the position and the unlikelihood anyone in the mainstream  media will do much to educate the American public on the facts).

Emotion-driven:  this should not be disrespected, but neither should it cloud the judgment as to what is in the nation's best interests.    Cuban-born residents of the US have gone through a lot of suffering.  My neighbor, in fact, was a child in a well-off family living on Fifth Avenue in the Miramar neighborhood in Havana, which was probably the most elite neighborhood there was,  when the revolution came.  The new government appropriated the ground floor of their residence, moved in a family they did not know, and confined his family to the second floor.  They lived that way for several years before they escaped in a small boat to Florida.  So there has been serious psychological suffering and certainly economic loss as well.  I believe these feelings will resolve once Fidel dies -- I think the expatriates will dance on his grave, and find closure that way.  However, it's unwise to wait for that.  The collapse of Cuba's options for avoiding rapprochement with the US has come sooner than Castro's death. and you have to take advantage of this opportunity to start the process, which is inevitable. And ironically the Cuban-Americans are the best positioned to profit from the new business opportunities normalization will create. 

Too blatantly political.   One great source of money for political campaigns and votes at election time, is outraged people  with lots of money.   So it's inevitable prospective Republican Presidential candidates like Marco Rubio, Ted Cruz and Jeb Bush are all going to be competing to capture the hearts and wallets of successful Cuban Americans offended by the President's action.  That's politics and both parties play it (see Wendy Davis's campaign).  But it's also short-term.  What normalization sets in motion is a machinery that will eventually produce material improvement in the lives of Cubans and I would hope that, in time, the Cuban-American community will start to focus on that. Trade and commerce are a better set of tools to bring about a change in the political climate in Cuba.

In the meantime, I encourage any reader to visit Havana before the tourist wave begins, because, while Havana's infrastructure was much better than I had been led to fear, I don't think it is up to the volumes of tourists that may descend on it once normalization occurs. Old Havana was, rightly in my estimation, designated a  World Heritage Site by UNESCO back in __ and in connection with that status, has been furiously renovating its many architectural marvels.  I had been expecting a widespread dilapidation, and there certainly are examples of that throughout the city, but where the buildings have been renovated, they are spectacular, the equal of Buenos Aires, and all but a few European cities.

The "Redemption Option Premium" in the ABI Chapter 11 Reform Proposals

The propositions diminishing secured creditors' protections deserve careful attention as I think that, while not as bad as was being advocated, they remain unsound policy. 

These changes fall under two main headings, first, diminished protection of the secured claim during the case and second, a prospective "haircut" in "senior" recoveries (the word "senior" is sometimes used specifically to mean secured claims, and sometimes ambiguously as possibly operating between levels of unsecured claims and sometimes even between the unsecured class vs equity).  For this post I am going to just focus on the second for now, because it is the more complicated and thus the one I have spent more time trying to understand. 

The crux of the proposed changes to distributions of value to secured creditors under plans and in 363 sales is to create a "redemption option premium" ("ROP" for shorthand), the definition of which has been carefully labored over and resembles ideas that have kicked around outside of the commission for a few years.  In broad summary, because it really is a very, very long definition, the immediately junior class to the class or classes receiving the "residual value" of the reorganized debtor would be entitled to receive value (form undefined) equal to the price (to be determined using the Black-Scholes option pricing method which I will discuss a little bit below) of a 3-year option with a strike price equal to the payoff amount for the entire senior debt plus interest at the non-default contract rate for the full three years. A couple of simple examples involving just one level each of secured and unsecured debt are sketched out in the report and it is asserted that where the senior creditors are recovering, say, 50% of their claim under the plan or sale, the impingement on their recovery would be quite small, and where they were recovering 90% of their claim, it would be larger. 

The concept of some kind of upside participation entitlement is not crazy -- as noted, others, including me, have suggested something like it (not this form, specifically).  It is appealing to have a "safe harbor" in the fair and equitable analysis, where the plan proponent can put a proposed recovery into the plan for a junior class and know it's going to be enough, as opposed to having the unsecureds take what's offered and litigate up from there.  The use of an option premium as a measure of the safe harbor amount  is logical and even elegant, if a bit challenging at first for the less financially sophisticated decision-makers.  The report indicates that the delivery of the ROP is linked to the class not objecting in certain ways, which I find very confusing on first read, but at least that somewhat creates the potential of reducing valuation litigation, which might be a good thing, although, as I explain below, I don't think, net-net, it would do so because you can't figure out the ROP until you have settled on the valuation - that is one of the essential inputs for figuring out the value of the option.

However, the size of the proposed option - an option to buy "the entire firm" is a radical change from present practice where the norm might be to offer the obviously out of the money class a sub-10%  equity stake or a warrant to buy a slightly larger stake, or at best a combination of both.  So that is a several-fold increase that would certainly affect plan bargaining.  True, the workings of the option pricing model will cause the value of the option premium itself to be a similarly small percentage of the total enterprise value, as I will demonstrate below, and the senior stakeholders may choose to dole out the value in another form.  But, as I will show below, the opportunity for an out of the money class to come out of a bankruptcy with of an option to buy the entire reorganized debtor could lead to overly levered capital structures and also to otherwise irrational claims trading in the case itself.

  

The Commission also creates a host of problems with its determination to impose the haircut on senior creditors non-consensually and in widespread fashion.  Many of these are reflected in a long paragraph on p. 211 and developed further in footnotes.  For example, at fn 764, it is argued that the secured creditors' deficiency claims must be excluded from the distribution of the value -- effectively mandating a subordination of those claims. Nor could the secured creditor make an 1111(b) election to get around that truncation. 

So too, in order to force the transfer of value on the parties, the commission has to propose to eliminate the requirement of section 1129(a)(10) that at least one impaired class accept the plan for it to be confirmed.  If that requirement remained, the plan would fail, as none of the other requirements of fair and equitable would necessarily be fulfilled.  That then poses a question the plan leaves largely unaddressed - why bother with disclosure and voting in such an environment, if everyone can be crammed down?  What is the benefit of disclosure and voting that requires time and money to be spent on it?

In my own experience, I have found 1129(a)(10) to be a hugely useful provision for tailoring plan negotiations because it empowers the plan proponent to say no to the less realistic fringe constituencies in the case. In my last big engagement before I retired, the Barneys restructuring, we were able to conclude the entire restructuring out of court in part because the one potential objector to the restructuring knew it could never succeed in confirming an alternative plan because it could never get one impaired accepting class - it had only a blocking position in a junior class, whereas the investor preferred by the debtor controlled the senior class and could deliver that class for the 1129(a)(10) requirement.   Pulling that requirement out of the Code would have deprived the debtor of its most impersonal argument for preferring the senior investor.  The debtor either would have had to make it a personal matter - we like them better than you, leading in all likelihood to the spurned investor launching all kinds of spiteful litigation, or more likely have forced the debtor into a long, public chapter 11 proceeding in which they went through the drill of making a record about due consideration of the spurned investor's ideas, which would not have had any benefit for the business as a whole.

Further, at fn. 763, the report observes that the requirement would "in theory" (whatever that means in this context) have to take precedence  over contractual subordination.   No policy justification is offered for these demands, they are merely logical implications of the concept of a forced transfer of value down the priority chain.  They seem almost petulant, in all honesty,  The whole purpose of contracts is to allocate risk.  Subordination is just a form of insurance - why eliminate insurance held by senior secured creditors but not insurance held by other kinds of creditors?  Yes, bankruptcy law authorizes breaking contracts - but those are the debtor's contracts; they're to be broken only to the extent they impede the debtor's reorganization, which insurance doesn't do; and in any case, the non-debtor counterparty is supposed to get a claim for damages from the breach and its allocable share of reorganization value to compensate it for the federal government destroying the contract.  This aspect of the recommendations is especially radical and indefensible. The ideas of (a) wiping out deficiency claims that would be in the money if separately documented, and (b) wiping out contract claims against a non-bankrupt also raise a host of Constitutional questions.  

Indicating how weakly developed and potentially confusing this idea is, fn 762 of the report states that the ROP would not apply to senior classes in a plan that were repaid in full in cash, or received only debt securities, because the give-up is only meant to apply to residual value of the firm.  They fail to recognize how that would affect plan bargaining: why would anyone want to pay the seniors off if they could haircut them -- the trick is obvious: give the seniors just enough equity to take away and redistribute!  No one's going to think of that?   A similar quirk arises because they advocate that,  in a sale context, the opposite of the plan rules would apply and the give-up would apply to cash proceeds or take-back paper. Obviously that has dramatic impact on plan vs sale negotiations and, as a second order effect, creates litigation over why the debtor chose one course vs the other.  The same footnote further admits the commission has no idea how the proposal would work where equity was distributed among multiple classes -- who gives up what and to whom? 

To explore that question, I applied these proposal to a representative capital structure for a mid -2000s LBO. to see how they might play out.  

Scenario: Debtor has first lien debt of 300 million at 5%, 2d lien debt of 100 @ 7%, and equity of 300.   This is a very   Imagine the value in reorganization is 350 (1/2 the LBO valuation).  This would mean the first lien lenders have gauged their risk correctly and lent prudently, exactly as society should want them to do -- until the ROP raises its ugly head  - while the 2d liens have misjudged their risk materially, but for the rescue embedded in the ROP, and the equity would be wiped out.

 

Under current law we would distribute the 350 of reorg value 300 to the first lien debt and 50 to the second.  The first lien would take some of its recovery in new first lien debt, e.g., 150 million, and the rest in equity, in this case worth 150, implying the second lien would hold its 50 million of value as a 25% stake in the reorganized debtor.  Equity would get nothing but a release for cooperating.

So we'd wind up with this capital structure at emergence:

First lien :            150 new debt

                            150  common

Second lien           50  common

Equity                      0

According to the Commission, the ROP would be calculated as the value of a hypothetical 3-year option to purchase the entire firm with an exercise price "equal to the entire face amount of the claims of the senior class, including its deficiency claim if any."  But according to fn 767, in cases where that class is not receiving all the equity of the reorganized debtor, "the redemption price would have to be adjusted to include the claims of all such senior classes whether or not they are receiving residual interest in the firm or are among the classes required to share reorganization option value with immediately junior class." 

So what is the ROP here?  Who gets it?  Is it based on the first lien debt (300 principal plus 3 years interest, or 345 total) or just their equity stake (150 plus 3 years interest at 5% or 22.5 million?  Or is it held by the equity and based on the total debt (400 principal or 466 with interest on both tranches)?  The report punts on this question.  So I will run through the various permutations.

Let's assume, not withstanding what the report says, you don't include the first lien debt because the option holder wouldn't really be "buying" that; it would just be refinanced.  That seems irrelevant to the focus on residual value.  If it's just the first lien equity stake of $150 million that has to be bought out at $172.5 million 9to include three years of interest), using the suggestion in the report that the default measure of volatility be the S&P 500's trailing four year volatility of approximately  15, and a risk-free rate (1.1% at this writing), that equates to an option premium of approximately $9.3 million, according to this website.  

Do note, however, that in all likelihood, using the S&P 500's volatility over a long period likely under-represents the actual post-emergence volatility of a single stock, which will have less trading liquidity, less market makers and will not reflect the partially contrary movements of 499 other stocks in an index.   For example, the stock of  American Airlines, which emerged less than a year ago, has been over 30 for the last three months. If the volatility of a stock is under-measured, then the corresponding call option is under-priced (an option is more valuable, the more volatile the underlying asset (because the option price is fixed)).  If the option is under-priced, it is more valuable as an option than as cash. That in turn implies stakeholder battles in the confirmation context over the form of the ROP.  I don't see how this is a systemic improvement.   

Another form of potential mispricing occurs because the commission recommends using the pre-petition loan documents' non-default contract rate in building up the exercise price of the option, instead of market rates at the time of confirmation.  If interest rates have risen, the option is underpriced.  If they've fallen, it's overpriced. 

Look also at the implications an actual option would have for the post-reorganization period.  The first lien debt really wouldn't really have the upside economics associated with a 75% equity stake in the reorganized debtor.  If the value goes up, the 2d lien would exercise its option and take them out and appropriate the upside all for themselves.  Yet the first lien would bear 75% of the downside economics of the stock position - it has no offsetting "put" option to transfer losses to the 2ds, post-emergence.  This "heads the 2ds win, tails the 1st lose" is hardly equitable.  They would likely demand that the equity be doled out in the form of preferred and common and take at least a portion of their equity in preferred.  

Such a capital structure might look like this:

First lien recovery:            150 new debt

                                             75 new preferred

                                             75 new common

Second lien recovery           50 new common

Equity                                    0

But that raises many new issues - does the preferred require cash dividends and can the enterprise pay them?  Does it count toward the exercise price? If not, then the ROP gets cut in half, down to $4.5 million (confirm this at the website used earlier).  So maybe the solution is to give the 2ds that lower ROP in the form of additional common, taking their recovery from 50 to 54.5, and be done with it.  But if the 2ds disagree, how does the plan proponent decide? And how does the judge decide?  There is no guidance at all in the report or in prior case law since this is an exception to all the law that has built up over the last century on the absolute priority rule.

And we haven't even looked at whether the 2ds are sufficiently in the money that the "immediately junior class" to receive the ROP  is the equity.  Equity's option to buy out the 200 in equity, which I calculate to have a strike price of $293.5 million (the sum of the foregoing 172.5 to buy out the the first lien's equity, and 121 to repay in full the second lien at the 3-year mark) million has a much smaller value, $2.5 million.  That is because it is more out-of-the-money than the 2d lien would have.  But do think about the implications of giving old equity a free three-year option to regain control of the company after a bankruptcy.  How would that influence the design of the initial capital structure?  I suggest it would lead to high-risk, over-levered companies. 

These scenarios show, among other things, that embodying the value of the ROP in an actual option would rarely be a good idea from a policy perspective. It would distort financing decisions ab initio, reorganization bargaining and post-emergence capital structures.

They also show there would be disputes over how to value the ROP, in what form to disburse it and  over who gets it - the second liens or the equity.  The Commission punt  on all those questions.

A fourth kind of dispute would arise over who bears the cost of the ROP  Especially if the proposal to emasculate contractual allocation of the risk by contractual subordination at the time financing is raised.  The intent of the proposals definitely points toward having the first bear the cost.  But which cost?  If the firsts transfer an ROP of $9.3 million to the seconds, they reduce their recovery by roughly 3%.  The seconds' recovery jumps by 20% though (from 50 to 59.3).  If it's $4.5 million, they reduce their recovery by 1.5% and the 2ds recovery goes up 9%.  If  they transfer an ROP of $2.5 million to the equity, they reduce their recovery only by 1%.  So they would tend to align with the equity on that distribution in the absence of a clear rule.  But will the 2ds go along with that? 

And, more broadly, is all this gamesmanship and bargaining over 1-3% of the total enterprise value an improvement over the current law and practice?  Because the redemption option is always out of the money, the ROP is going to be rather small fraction of reorganization value, unless radically different volatility numbers get used.  These issues certainly contribute nothing to the actual viability of the reorganized debtor.  And, in a representative situation such as I just outlined, the ROP does not even appear to accomplish the purpose of avoiding valuation litigation at confirmation.  To some extent, my hypothetical dodged the valuation question that would be litigated at confirmation, by assuming one before trying to determine the ROP.  But the Commission does not propose a mechanism whereby the valuation is determined anytime before confirmation.  So it seems false advertising to argue this approach would forestall valuation litigation -- there is no way to do so in advance of knowing the valuation and the parties' take on it..  Do you think the offer of $4.5 million to the seconds would be enough for them to consent if they think the enterprise value is 10% ($35 million) higher?  Remember they get all of any increase. It might buy off equity, but if that doesn't change the 2ds' argument, nothing has really been gained. The bottom line is, if you're going to reach agreement on a valuation to begin with, you don't need the ROP to achieve consensus; and, if you're not going to reach agreement on a valuation, the ROP is not going to spare you litigation.  It just seems a fallacious argument.

The commission's report portrays it as a shortcoming of current law and practice that the absolute priority law wipes out junior classes in a "random" way depending on the vagaries of the timing of their filing in the economic cycle.  Even assuming arguendo that is true (why is it anymore random than any other event in relation to the business cycle? And is it all that random, because debt contracts are a big factor in bankruptcies and there is nothing random about their terms - maybe they were just badly designed in relation to the business cycle.), if what's being lost is an out-of-the-money option worth less than 3% of the enterprise value  -- on one investment in what is likely a very diversified portfolio  held predominantly by institutional investors  -- that's just not a big enough loss to overhaul a century of well-defined law and decades of familiar practice. 

The report itself, at p. 211, acknowledges that the ROP "requires further development", i.e., it's not ready for prime time and should not be considered ready to go into effect.  And I think this post illustrates the accuracy of that recognition.  To me, overall, the gain is not worth the candle, But, I could imagine that the ROP might -- if (a) it were simply a measure of value that you can pay a junior class to deem it to accept, and not an actual option to buy the firm, (b) it required the consent of the senior class making the give-up, and (c) were very clearly defined and allocated by statute -- be a useful option for plan proponents to get cases over faster.  It would turn into a sanctioned form of "gifting" -- which ironically elsewhere the Commission rejects (which is a whole other angle for criticism of the ROP -- if voluntary gifting is bad, why is mandatory gifting good?).  All these other radical changes would then be unnecessary, as it would be a voluntary give-up of the package of ROP value, deficiency claims, contractual subordination, and, since it would be voluntary, you would not need to remove 1129(a)(10) from the Code and it could keep on doing its useful job of streamlining the plan formulation process.

The Slow Food Movement May Be Coming to Chapter 11

The ABI Commission's report on chapter 11 reforms was released today.  It certainly is a lengthy document, as one might expect from a committee whose membership is dominated by lawyers.   Much of it proposes not what I would call "reform" but simply "codification", which is generally welcome -- e.g., inserting the Countryman definition of an executory contract; selecting the "actual" as opposed to the "hypothetical" test for assumption;  blessing use of estate property to pay critical vendors or prepetition employee claims; overruling all of the "Till in chapter 11" decisions; codifying the "new value" exception to absolute priority;  and so on.   

The major changes proposed consist generally of reducing the rights of secured creditors during the administration of the case, and to some extent at the end as well, although in the latter instance the impingement on secured creditor rights is not as dramatic as many of the commission members' statements from time to time over the past two years advocated.

 

Also, section 363 practice receives a good deal of attention.  Some of this is in the nature of codification of procedural aspects such as length of time before a debtor can initiate a sale.  Prevailing interpretations that confer on certain contract counterparties leverage to block 363 sales, like patent and copyright licensors, would vanish.  363 sales are recognized to be plan-like in some respects, for example, the cutting off of claims is recognized to be like a discharge, with various notice and due process implications that flow from that; and the proposal to impinge on secured creditor recoveries in the plan context is carried over to the 363 context.

Other proposals strive to lengthen the time companies spend in chapter 11 - explicitly , early milestones for plan or sale filings would be forbidden from cash collateral and DIP financing orders; time to assume nonresidential real property leases would be extended to one year, etc.  Implicitly, certain other proposals with respect to distribution of value could produce longer cases, as it would take a long time to figure out how to bargain around them, or to the extent the proposals actually subvert bargaining, how to administer cases around them.  

In this last respect, that of elongating restructurings, the report adopts one of the oddest perspectives I have seen emanate from any industry.  In so many other sectors of the economy  -- making a car or a computer chip; getting a new drug on the market; getting your first-round draft pick onto the field; delivering a product from warehouse to consumer -- achieving your objective sooner and cheaper would be considered a good thing and something that the sector should strive for.  Here, the report (p. 221) includes a chart showing a general decline over time in the number of days companies spend in chapter 11 -- and portrays it as a problem that needs to be solved.   I was going to write, "I cannot think of any other industry where slowing the process down is considered a process improvement", and then I thought of the "slow food" movement  and realized there was at least one.  I could not write what I was going to write, but it did suggest an entertaining title for the post. (Note to self: if these proposals go through, open up restaurant in Wilmington Delaware.  More people will be spending more time there and will need places to eat.)

But the "slow food" approach to dining is an option, not a mandate.  None of us likes to go into a restaurant and have no choice but to accept slow service at a higher price than we think we need to pay.  Why should that be a characteristic of business reorganization?  

 I don't see any evidence in this report that increased efficiency of debt restructuring has had a negative effect on continuity of jobs or any other public interest implicated in reorganizations.   It is argued that earlier exits lead to lower recoveries by junior constituencies, but it is also recognized that the asserted correlation cannot be distinguished from what might be caused by normal economic cyclicality.  No one can pick the top of the economic cycle -- how many people even predicted the recent plunge in the price of a single commodity, oil?  It's pretentious to suggest that bankruptcy law changes are going to systematically improve the timing of a company's exit relative to the economic cycle.  It also needs to be recognized that these are purely distributional issues: there is no going concern value being lost by the economy as a whole.  It's just a question of in whose hands it winds up.

Which brings me to a related point.  Setting aside again involuntary creditors, the distinction between senior secured and junior unsecured classes that drives much of the report's most controversial recommendations seems to me to be largely fallacious and antiquated.  In the modern restructuring era, the specific names who show up as senior secured creditor in one case may be junior unsecured creditors in the next.  These claims are held by pools of capital - hedge funds being the most obvious example, but there are plenty of bank loan and high yield mutual funds too.  Even corporate financial institutions, like commercial banks, investment  banks or insurance companies, are just pools of other people's money.   Many of these entities have diversified portfolios of investments, such that it's fallacious to think of them as systematically always senior or always junior - with an exception for commercial banks who are required to follow safe and sound banking practices that typically, as interpreted by regulators, include taking collateral.  And even if there are less-diversified institutions that focus predominantly on  one kind of investment, for example a fund that is purely a distressed debt fund, they tend to be doing so ultimately for the economic benefit of stakeholders who themselves have diversified portfolios. The distressed fund may be seeded by an investment bank or a larger multi-strategy fund that doesn't want to have a permanent infrastructure or to have its name associated with distressed situations.  Or they may be pension funds or university or charitable endowments that have widely diversified portfolios.  The point being, don't get all worked up about senior creditors winning too often - ultimately, the investor class holds portfolios of investments and no one is being systematically screwed or privileged. Focus on making the process efficient instead, which generally means clear and predictable rules, in this case the absolute priority rule that the financial markets have had a century to adjust to.

I will comment on the anti-secured-debt proposals in the following post.

A Deep Dive Into Case v Los Angeles Lumber Products, The Most Important Corporate Reorganization Case of the Great Depression

November 6th was the 75th anniversary of the Supreme Court's opinion in Case v Los Angeles Lumber Products, a date that I certainly did not have circled on my calendar, but which I came across in a passage on the case in an old textbook I was reading.  As many actors in the restructuring field have recently lost sight of the policy benefits of the absolute priority rule, this anniversary seems like a good occasion to look back at the case (forgive the pun) and its significance, then and now.

If you ask someone today what the issue was in Case, the most likely answer will use the phrase "the new value exception to the absolute priority rule" in one way or another -- as if the case was all about an exception to the rule.  It wasn't, though.  It was actually a historically significant reaffirmation of the absolute priority rule which occurred because a really small, almost irrational bondholder played a nuisance value strategy to the hilt at a moment when the leading legal minds in Washington D.C.  were searching for a vehicle to impose greater discipline on the interminably slow, inefficient and fairly sleazy restructuring model that prevailed as a matter of practice in that era.  Also, while the New Deal era's reforms of corporate reorganization law in the wake of the Depression had been substantial, the Court had not addressed whether those laws impacted the continuing vitality of the absolute priority doctrine, see e.g. Northern Pacific Railway v Boyd, 228 US 482 (1913), which was being honored only in the breach in actual reorganization practice.  "This complacent attitude toward the rights of creditors", one scholar wrote, "was rudely shocked in the autumn of 1939 by what was, in substance, a fundamental pronouncement by the United States Supreme Court."   The New York Times article reporting the decision said "New Dealers are privately hailing the decision ... as probably the most important decision in the realm of corporate law in a decade."  Since that "decade" began just days after the Great Crash, it is safe to say that it was seen by contemporaries as the most important decision in the realm of corporate finance during the Great Depression.

 

Factual background

The Los Angeles Lumber Products Company was a holding company with six subsidiaries of which only one, the Los Angeles Shipbuilding and Drydock Company, was significant enough to warrant at attempt at restructuring.  It prospered during World War I, but its business plummeted after the war ended.   The parent obtained capital in 1924 by issuing bonds secured by the physical plant of the drydock subsidiary, a small amount of which ultimately wound up in the hands of Case and his co-litigant, Cowan.  That bond debt was the only debt that was involved in the reorganization proceeding that reached the Supreme Court.

In 1930, the company had to be restructured to survive in the Depression aftermath.  The majority of stockholders injected substantial additional cash, taking back a new issue of equity that was preferred to the common, and the bondholders agreed to reduce interest from 7.5% to 6%, and even the 6% became payable only to the extent earned, for the remainder of the term of the bonds - 14 years!

Notwithstanding the lack of pressure from the bonds thereafter, the company still struggled throughout the 1930s, and wound up proposing a plan of reorganization in 1937 to de-lever itself.  The process they followed resembles very much what we would today call a pre-negotiated plan: the deal was negotiated out of court  -- "over 80% of the bondholders and over 90% of the stock assented" -- and when the company filed its petition for reorganization in January, 1938, under § 77B of the Bankruptcy Act, it did so "with the plan attached and reciting, inter alia, that the required percentage of security holders had consented to it." Under the law of the time, it still had to obtain court approval for a full solicitation and thus it wasn't what we call a "pre-packaged" plan.

The Original Plan -- "Relative Priority"

The plan, like the capital structure, was simple: the company was valued at $830,000 (roughly 22% of the secured bond claim of $3.8 million).  The bonds were converted entirely into 77% of the reorganized business' equity, embodied in a preferred instrument, while the class of old preferred shareholders retained the rest of the equity, 23%, as common, maintaining the junior relationship to the bondholders in the new capital structure, a practice referred to contemporarily as "relative priority" so as to contrast with the "absolute priority" rule that wiped out old equity.  There was no other debt to be dealt with and the original common was wiped out. 

As the "relative/absolute priority" dichotomy is the crux of the decision, it is worth providing some historical context for the prevalence of the "relative priority" approach to resolving distressed businesses in that earlier era.   The vast majority of businesses  were local or regional in nature and often closely held.  Management and ownership overlapped to a significant extent.   A large class of professional managers, such as exists today, did not exist back then to permit creditors to confidently replace the incumbents. And the owner-managers were often prominent figures in the community where the judicial district was located. such that it may have been socially problematic for a judge to dispossess them ruthlessly of the business stake that conferred such status.

Conversely, bond issues were, relative to the equity, more widely held.  Their promise of long-term, fixed, regular payments made them ideally suited to be held, when not in default, by "widows and orphans" and their institutional proxies, such as insurance companies, who often had no presence in the district where the reorganization proceeding was conducted.  Local banks tended to provide business credit only on very short maturities, or subject to demand.  There was no FDIC backing deposits, and prudent bankers had little choice to manage their liquidity risk but to conform their assets' maturities to their liability profile.   Finance companies existed, to provide secured working capital financing primarily, and the role played today by hedge funds, of providing expensive rescue money to relieve a company of short-term financial pressure, was performed by investment banks like JP Morgan, who were easily demonized when it came time to exercise remedies.

 

This combination of factors gave equity holders leverage in restructuring negotiations and frequently led to outcomes grouped under the rubric of "relative priority" or "composition".   Neither phrase was prescriptive in the way that the absolute priority standard is.  Rather, they were merely descriptive - the security holders got together and reached a bargain over who would get what in the reorganized enterprise.  Each constituency was generally expected to make some compromise of its rights, and the relative ranking ex ante was more or less maintained ex post, but often equity was able to retain a significant stake in the reorganized capital structure, although sometimes they had to buy that stake with fresh cash, as the Los Angeles Lumber shareholders had done in the 1930 restructuring.  Frequently the bargaining resulted in senior secured creditors receiving a package of several different securities, often including unsecured income bonds (bonds payable only to the extent of available income) and equity, but generally getting the vast majority of any secured debt remaining on the balance sheet after a restructuring. 

Litigation at the District Court

After approval by the District Court, Los Angeles Lumber's reorganization plan was formally assented to by approximately 93% of the face amount of the bonds, 99.75% of the Class A [old preferred] stock, and 90% of the Class B [old common] stock.

Case and Cowan, the petitioners, owned $18,500 face amount of the bonds - less than 1% of the issue.  Today, they would be barred from litigating the "fair and equitable" standard by the combination of sections 1126(c) and 1129(a)(8).  But back then, any creditor could raise that objection (as today is the case with the best interests test) and indeed part of the Supreme Court opinion stressed the irrelevance of the degree of acceptance by others.

Case wanted to be paid in full: par. accrued interest and expenses, for a sum of about $36,000.  Case had apparently succeeded in extracting payoffs via the holdout tactic in other reorganization situations before.  Poignantly, workers at the shipyard, among others, took up a collection to try to raise the payoff amount, but fell a few thousand short.  Case refused to compromise his claim - it was all or nothing.

The plan of reorganization was confirmed over his objection.  The District Judge listed 4 typical "relative priority" explanations why the plan was fair and equitable to secured debt holders, as summarized in the Supreme Court opinion:

1. It will be an asset of value to the new company to retain the old stockholders in the business because of 'their familiarity with the operation' of the business and their 'financial standing and influence in the community'; and because they can provide a 'continuity of management.'

2. If the bondholders were able to foreclose now and liquidate the debtor's assets, they would receive 'substantially less than the present appraised value' of the assets.

3. By reason of the so-called voluntary reorganization in 1930, the bondholders cannot foreclose until 1944, the old stockholders having the right to manage and control the debtor until that time. At least the bondholders cannot now foreclose without 'long and protracted litigation' which would be 'expensive and of great injury' to the debtor. Hence, the virtual abrogation of the agreement deferring foreclosure until 1944 was 'the principal valuable consideration' passing to the bondholders from the old stockholders.

4. Bonding companies are unwilling to assume the risk of becoming surety for the debtor or its principal subsidiary 'because of the outstanding bond issue'. The government's construction program will provide 'valuable opportunities' to the debtor if it is prepared to handle the business. Hence, the value to the bondholders of maintaining the debtor 'as a going concern, and of avoiding litigation, is in excess of the value of the stock being issued' to the old stockholders.

Getting to the Supreme Court

In his appeal, Case entered into a stipulation that drew the attention of both the circuit court and the Supreme Court, agreeing that he could raise "questions of substantive law only".  The circuit court found this somehow forced them to affirm the District Court.   But when Case petitioned for a writ of certiorari, Robert Jackson, then Solicitor General and later-to-be Attorney General and Associate Justice, seized upon the dispute, so framed, to be an ideal vehicle to get the Court to put its imprimatur on the absolute priority rule.  Thus he filed amicus briefs on behalf of the recently formed SEC and the ICC in support of Case's position, and in particular arguing forcefully that whether the plan satisfied the "fair and equitable" test was a pure question of substantive law and the Court was not precluded by the stipulation from resolving it.   His brief admitted, "Intrinsically the case before the Court may not be of major importance.  But the very simplicity of the case lends it significance in the law of reorganization."  The fact that Justice Douglas, who wrote the opinion, had been chair of the SEC immediately before taking the bench no doubt accounts for the close congruence between his views and those advocated on the SEC's behalf by Jackson.

The Court was clearly of like mind as Jackson, taking the case, declaring that it was not bound by the stipulation from evaluating the plan's compliance with the fair and equitable rule, and overturning the plan's confirmation in a unanimous opinion authored by Justice Douglas, issued only 19 days after the oral argument.

Before getting into the substance of the opinion, why was it of such concern to Robert Jackson and the Court that the absolute priority rule be reaffirmed?  Three reasons suggest themselves.   

First, a prominent example of the "relative priority" approach to corporate reorganizations, the Chicago, Milwaukee and St. Paul Railroad, which emerged in 1928 after a 3-year proceeding, had failed again in 1935, just three years before Case got to the Supreme Court.  That early "chapter 22" was cited by some at the time as evidence that the "relative priority" approach too often failed to "fix" the debtor's financial problems and instead served to prolong a complacent approach to over-leveraged capital structures at the expense of the public interest.  (This is another history lesson that should be recalled when one hears contemporary experts claim that the strict enforcement of absolute priority for the benefit of senior secured creditors somehow leads to businesses not being properly fixed - the lesson of the Depression was exactly the opposite).

By taking the Los Angeles Lumber case, Jackson and Douglas intended to systematically improve outcomes in reorganizations by reaffirming unmistakably the absolute priority rule and consigning "relative priority" to the dustbin of history.  As a later commentator, Arthur Stone Dewing, wrote, "Jackson cared not a farthing for Case or his bonds, and prayed for the Court to set aside the Los Angeles reorganization plan in order to confirm a specific theory of creditor rights .... To this end, Case and the Los Angeles Lumber Products company were guinea pigs in the Washington laboratory."    

Second, Douglas in particular had a seriously jaundiced view of the process by which reorganization plans had generally been negotiated up to that point, perceiving them to be rife with insider dealings and favoritism designed to perpetuate control by often dishonest management and their financial allies, all of whom he sneered at as "financial termites".  As he said in a fire-breathing, Elizabeth-Warren-style speech in Chicago in 1936, these "financial termites" used the reorganization process "not as a device to settle the accounts of the old company but to prevent those accounts from being settled and to restore to power those who ruined or participated in the ruin of [the] enterprise."   Thus, Douglas was eager to have an opportunity to issue an opinion that would, in effect, throw the moneychangers out of the temple.  The absolute priority rule made for less haggling and thus less delay, made changes in control more likely, settled accounts more effectively than the alternative, which tended to prolong over-leveraged capital structures, and protected the widow and orphan constituency that was seen to populate the ranks of senior secured bondholders.  Those views were widely shared and accounted also for the imposition of SEC (or ICC in the case of railroads) supervision of public company reorganizations in New Deal era reforms. 

And this is how the decision was perceived among Douglas and Jackson's fellow New Dealers, according to the New York Times article cited earlier assessing the impact of the decision:  "Not only will it speed corporate reorganizations by clearly eliminating stockholders from reorganizations in which there is not sufficient property to satisfy the obligation to creditors but it will end what one of them called the 'racket' of obstructing such proceedings by attorneys who represent equity security holders."

Last, as noted earlier, "relative priority" reorganizations often had elements of local favoritism at the expense, as noted earlier, of more distant bondholders.  But when the Court issued its reaffirmation of the absolute priority rule in Case, that holding was applicable nationwide.  The forceful imposition of a national standard was very much in keeping with the prevailing view of the leading policy makers of the New Deal, like Douglas and Jackson, who saw state, local and regional practices - and judicial limitations of  federal pre-emption -  as inadequate, antiquated and backward, and consistently set out to pre-empt them with bold new enactments at the national level.  

That was very much in keeping with the original intent of the Bankruptcy Clause in the Constitution, which was meant to empower Congress to overcome local favoritism that discriminated against out-of-state creditors. See this site for a good concise recitation of that history.

Supreme Court Opinion

After reciting the facts and confirming that the Court considered the "relative/absolute priority" question to be one of law,  Justice Douglas unambiguously made clear that the absolute priority approach was the law of the land.  In a pair of locations, the Court squarely held that the business reorganization statutes enacted by Congress embedded the Court's prior adoption of the absolute priority rule in the statutes' use of the phrase "fair and equitable":

The words "fair and equitable" as used in § 77B, sub. f are words of art which prior to the advent of § 77B had acquired a fixed meaning through judicial interpretations in the field of equity receivership reorganizations. Hence, as in case of other terms or phrases used in that section, ... we adhere to the familiar rule that where words are employed in an act which had at the time a well known meaning in the law, they are used in that sense unless the context requires the contrary. [citations omitted].

After reviewing four prior precedents consistent with absolute priority, the opinion continued:

Throughout the history of equity reorganizations this familiar rule was properly applied in passing on objections made by various classes of creditors that junior interests were improperly permitted to participate in a plan or were too liberally treated therein. In such adjudications the doctrine of Northern Pacific Railway Co. v. Boyd, supra, and related cases, was commonly included in the phrase 'fair and equitable' or its equivalent. As we have said, the phrase became a term of art used to indicate that a plan of reorganization fulfilled the necessary standards of fairness. Thus throughout the cases in this earlier chapter of reorganization law, we find the words "equitable and fair'', "fair and equitable", "fairly and equitably treated", "adequate and equitable", "just, fair, and equitable" and like phrases used to include the "fixed principle" of the Boyd case, its antecedents and its successors. Hence we conclude, as have other courts, that that doctrine is firmly imbedded in § 77B.

(As the 1978 reforms preserved the phrase "fair and equitable" in chapter 11 confirmation standards, the doctrine remains "firmly embedded" in section 1129 and these cases remain instructive for current practice.  The Code did, of course, ingeniously embed in section 1129)(a) ( ) the option to bargain away the "fair and equitable" standard as long as the requisite voting margins are obtained, which is a vestige of relative priority practice that continues to survive. Likewise, the current Code further facilitates "relative priority" practices by divesting the SEC of any substantive role in reorganizations.  But the only defensible interpretation of the phrase "fair and equitable" in section 1129(b) is that dissenting creditor classes are intended to receive the full protection of the absolute priority rule as fleshed out in these earlier Supreme Court precedents, and not be haircut a la the recent MPM decision)

Douglas then made clear that, where the debtor was patently insolvent, the equity was supposed to be wiped out by enforcing the absolute priority rule rigorously.  This, he recognized, was at odds with decades of practice, in railroad and other reorganizations whereby equity and other junior security holders were allowed to buy back into the reorganized debtor with fresh capital, a practice known as "assessment" which was probably the predominant method of reorganizing American businesses in the late 19th and early 20th century.  He allowed that the practice could be harmonized with the absolute priority approach, so long as the new stakes were fairly valued.  This is how we get, today, the "new value" doctrine: "the stockholder's participation must be based on a contribution in money or in money's worth, reasonably equivalent in view of all the circumstances to the participation of the stockholder."

Of course, in Case, there was no fresh capital contribution by old equity, merely the four indirect benefits cited by the District Judge in confirming the plan.  Justice Douglas disposed of each of them briskly.

The first rationale supplied by the District Court  - continuity of management - as I noted above, was a common proposition supporting old equity in pre-war restructurings, for reasons reflecting the characteristics of business management in that era.  Justice Douglas blew that away, reasoning instead that such "ephemeral" contributions fell short of what was required by the "rigorous standards of the absolute or full priority doctrine of the Boyd case." 

The second rationale supplied by the District Court  - defining "fair and equitable" to mean just doing better than in a liquidation (essentially a "best interest" argument) was summarily rejected by the Court.  The paragraph in the Supreme Court opinion containing this refutation is on the conclusory side, -- basically, it says, "fair and equitable" means absolute priority, and liquidation value is irrelevant to absolute priority. They don't say why, but I think we can interpolate the obvious steps that, if absolute priority means the secured creditor gets to keep all the value until it's paid in full, that implies that liquidation value does not cap the secured creditor's priority and once that is understood, liquidation value becomes irrelevant to the absolute priority analysis.  At another location in the opinion, the Court quotes Northern Pacific Railway v Boyd to this effect: "If the value of the road justified the issuance of stock in exchange for old shares, the creditors were entitled to the benefit of that value, whether it was present or prospective, for dividends or only for purposes of control. In either event it was a right of property out of which the creditors were entitled to be paid before the stockholders could retain it for any purpose whatever."  The premise in that quote necessarily contemplates the railroad operating as a going concern, so when the Court refers to "that value, whether it was present or prospective, for dividends or only for purposes of control" it is referring to a going concern value that it says - twice - the creditors are entitled to. So if the secured creditor is entitled to going concern value, liquidation value is irrelevant.  (It is definitely worth re-reading these old cases today, when so many bankruptcy experts claim the secured creditor were somehow always meant to be capped at liquidation value - clearly Boyd and Case address that proposition directly and deliver the opposite lesson.)

The third rationale supplied by the District Court - that, given the 1930 restructuring eliminated the ability of the secured creditor to foreclose for payment default prior to bond maturity in  1944,  the stockholders were doing the bondholders a favor by turning the company over sooner - was rejected by the Court in a rather high-handed and even circular manner, simply by saying that, once you file for bankruptcy, federal law takes over, the debt is accelerated by law (they don't say that, but that is how we think of it today) and the contractual maturity no longer matters, you get the rights the statute provides. 

The Supreme Court broke the District Court's final rationale into two paragraphs.  The first  -- equity participation is OK because equity has nuisance value and accommodating them resolves the reorganization more efficiently -- the Court squashed forcefully, saying that the reorganization court had a duty to rule in accordance with the law and "should never yield to such pressures".  (The Court failed to note the irony of characterizing the cooperating equity as purveyors of nuisance value in a dispute prosecuted by a holdup bondholder.)

The second paragraph, though, has real resonance today, as the Court rejected the claim that it was fair to make the secured bondholders share the going concern premium with equity, which would have been lost in a liquidation but was preserved by equity's cooperation.  Liquidation was not the only alternative; a court could approve a going concern reorganization that delivered all the ownership to the secured creditors, and the opinion cited to other plans that had done just that. Equity was entitled to nothing for having filed a voluntary petition for reorganization as opposed to the company being forced in by an involuntary petition. Again, we see the Court emphasizing that secured creditors get going concern value.

Other Implications for Current Issues

The decision also provides further similar insights in relation to current rhetoric about bankruptcy reform to the detriment of secured claims.  These are not stated explicitly, but become evident and inevitable from the facts and the holding.    This was a case with only two classes - secured debt and equity.  As the plan's distribution to equity was invalidated by the Supreme Court, it follows that the only permissible outcome, per a unanimous Supreme Court, was for the reorganization court to give all the equity to the secured creditors.  Remember that when you hear academics and U.S. Trustees and unsecured creditors' committees claim that it is somehow improper for a chapter 11 case to be run "only for the benefit of the secured creditor".  Case was decided so as to require the court to deliver all the value of the debtor to the secured debt.  It cannot be interpreted any other way, because there was only the secured debt and equity which lost its entire distribution.

Likewise, note that, contrary to some modern-day interpretations of section 1129(b) that I have seen, the Supreme Court did not say, only unsecured creditors can invoke the absolute priority rule, as the petitioners in Case were plainly secured creditors. Review was undertaken and relief granted and the reorganization was modified, all for the sole benefit of the secured creditors.

Subsequent History

The subsequent history of the reorganization was not without its small ironies.  On remand, the District Court confirmed a modified plan that gave all of the company's equity to the bondholders and eliminated old equity.  To compensate Case and Cowan for their success in enhancing the bondholders' recovery, they were given additional shares in the company  -- but they never got the cash payout they had been striving for.  So they continued to object and again the lower courts rejected them.  Again, they sought cert from the Supreme Court, but -- further proving that they had merely been the vehicle for Douglas et al to reform reorganization practices -- the Court denied their second petition. 

Due to the increase in shipbuilding orders to assist the United Kingdom hold off Hitler, and to prepare the US for war, the company prospered almost immediately. At one point in 1941, the equity received in the reorganization had approximately quadrupled, making it almost equal to the bondholders' pre-petition claim.  While the company remained active during the balance of the war, business again collapsed in peacetime, and the facility was liquidated at the end of 1946.

But it had served its purpose for the New Deal reformers in Washington D.C. and lives on in our law, 75 years later.

A note on sources 

Everything above that does not come from the opinion or the New York Times article mentioned comes out of chapter 40 of "The Financial Policy of Corporations" by Arthur Stone Dewing (Fifth ed. 1950).  This old textbook, which is both out of print and out of copyright protection, was given me by an uncle, who saved it from his classes in Wharton.  Dewing's work was one of the first corporate finance textbooks used in business school.  Dewing (1880-1971) was one of the founders of Harvard Business School and taught there for many years. A surprisingly large portion of the book deals with corporate reorganizations, and it is an excellent source of information about earlier practices and results.