Monday, December 1, 2014
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.
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.
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.