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.
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