Capitalizing on Security Exemptions

CAPITALIZING ON SECURITY EXEMPTIONS IN CHAPTER 11
REORGANIZATIONS

by Daniel J. Demers, M.B.A.”‘
and L. Paul Hudgins, J.D. **
In collaboration with Sidney J. Diamond, J.D., John D. Shirley, C.P.A., and Blake Wilson
© Demers & Hudgins 1998

The Bankruptcy Code (hereinafter the “Code”) contains a number of security exemptions enunciated by Congress in 1978. In granting extraordinary authority to the bankruptcy courts Congress stated, [t]hese provisions are necessary because the rigidity of the securities laws conflicts with the need for flexibility in bankruptcy cases,” and “On the interaction between bankruptcy law and other laws, each bends somewhat to accommodate the policies of the other.”

Unfortunately, the reality is that seventy five percent (75%) of all bankruptcy reorganizations fail.’ The authors assert that if bankruptcy professionals fully understood the security exemptions available under the Code and the availability and use of equity to retire debt then the number of bankruptcy reorganization failures could be substantially reduced.” As such, this article will explore two types of “public companies”: the non-reporting public company and the reporting public company and the requirements of each to each equity securities emerging from bankruptcy.’

Public Companies

The Code does not define the term “public company.” Originally Senate Bill S2266 contained a clause defining “public company” as a “debtor who, within 12 months prior to the filing of a [Chapter 11] petition … had outstanding liabilities of S5 million or more . . . and not less than 1,009 security holders.” However, this provision was removed during the Congressional Conference Committee by House and Senate negotiators after “the House prevailed, and the consolidated chapter [i.e., the Code] did not differentiate between public and non-public companies.” As such, the definition of “public company” must fall to the technical definition provided in Title 17 of the Code of Federal Regulations.

The Non-Reporting Public Company

The Non-Reporting Public Company’s stock, if traded, is typically referred to as Over the Counter (OTC), Pink Sheet, or Electronic Bulletin Board (EBB) equity. The difference between pink sheet and EBB equity is that the former is a non-real time electronic quotation service, while the latter is a real time electronic quotation service. The EBB service is provided by the Nasdaq Stock Market while pink sheet quotations are provided by the National Quotation Bureau. Neither is affiliated with the other.

A non-reporting public company can only be traded through the pink sheets or on the EBB. In order to become a non-reporting public company, the company must locate a sponsoring market maker who will sponsor the company to be traded, and file a Form 2-11 in accord with 17 C.F.R. § 240.15c2-11. Form 2-11 is submitted by the market maker to the appropriate listing agency which, after review for compliance, permits trading. Form 2-11 is a simple and straightforward application prepared by the sponsoring market maker.

For the reorganizing corporate debtor desiring to be a non-reporting public company, attachments of its most recent balance sheet, profit and loss statement and retained earnings must be provided to the OTC listing agency. Additionally, the same information for the two preceding fiscal years, or its predecessor, must be provided. “Recently the S.E.C. has agreed to modify this requirement for companies emerging from Chapter 11 proceedings by requiring an accounting as of the Confirmation Date by the Bankruptcy Court. Currently, the S.E.C. is proposing that a market maker need only review the Court approved Disclosure Statement along with the financial statements in order to sponsor the Reorganized Debtor.” For trading on the EBB or the Pink Sheets, certified accounting is not required, only an accountant’s review. Once approved by the “OTC Bulletin Board,” a company has no further reporting requirements imposed upon it by the quotation service. Since a Bankruptcy Plan of Reorganization may issue equity securities of a debtor as a method of retiring debt, non-public companies may technically become public companies by this mere act.

The Reporting Public Company

A reporting public company is one which files a Form 10 with the Securities and Exchange Commission of the United States (hereinafter “SEC”). By law, a company which has a combination of $10,000,000.00 in assets and 500 or more shareholders must file a Form 10 or Form 8A with the SF-C.” Many companies file a Form 10 voluntarily even though they don’t have the mandatory assets and shareholders for filing.

A Form 10 public company must file quarterly statements with the SEC (10 Q’s),” and once annually (10 K).” The annual 10 K includes a certified audit performed by independent certified public accountants. Certain essential events can trigger the requirement that supplemental information must be reported during each quarter on a Form 8 K, 16 such as the resignation of a director, termination or resignation of independent auditors or the filing of a petition for bankruptcy.

Most companies that file a Form 10, do so only because fully reporting public companies can be listed on a stock exchange such as Nasdaq, American Stock Exchange, or the Boston Stock Exchange. However, a reporting company must still comply with the individual exchange listing requirements before its equity can be traded. For example, the Nasdaq SmallCap Market requires that a before a company can be listed it must have a minimum of 54,000,000.00 in tangible assets or $50,000,000.00 in market capitalization or a net income of $750,000.00 per years for the previous two years and a minimum bid price for the company’s stock of $4.00 per share.” Once listed, however, maintenance requirements are generally relaxed from initial reporting requirements.

Like the non-reporting public company, a reporting public company must locate a sponsoring market maker to file a Form 2-11 pursuant to 17 C.F.R. 240.15c2-11 in order to activate trading of its securities. Currently, the S.E.C. staff treats reporting companies that seek protection under Chapter 11 differently that non-reporting companies. On April 15, 1997, the Division of Corporate Finance for the S.E.C. published Bulletin No. 2 clearly enunciating that a new policy not approved by the S.E.C. was being implemented, but only on the S.E.C. staff level. Basically, the now policy requires reporting companies to prove to the S.B.C. that they cannot continue to issue quarterly and annual reports and, If proved, the staff will allow Chapter II reporting companies to issue a monthly with a copy of the Debtor’s Monthly Operating Report attached thereto in February of 1998, the S.E,C. proposed a modification to Rule l5c2- 11 which would effectively stop trading of reporting companies in Chapter 11 which do not maintain the filing of quarterly and annual reports.”

Compliance with State Security Laws

Once securities are issued, the reorganized bankruptcy debtor must comply with statutory listing requirements in order to create a secondary market for the newly issued securities. Most states require that a company be listed in one or more manuals” provided by national services such as Standard and Poor’s or Moody’s investor Services. A company must be listed in one or more of the manuals before a stock broker can trade the company’s stock in the state in which the trade is to be made. The cost of listing in one of these manuals is approximately $975.00 annually, after an initial listing fee of $3,975.00. Seventeen of the states do not recognize these manual listings and require a registration or qualification for secondary non-issuer trading which includes paying a fee to those Macs” This means that the company must file with the state securities commission or division and be approved by the state before its stock can be traded. However, because stock issued through a bankruptcy plan of reorganization is exempt from registration under the Securities Act of 1933, companies emerging from Chapter II do not have to comply with registration or qualification in these states.”

Various state statutes require that listings include certified audits of the company for the previous five years. However, a company emerging from Chapter 11 reorganization has no financial past. The American Institute of Certified Public Accountants (AICPA) has expressed that “entities emerging from Chapter 11 will not be comparable with those prepared before their plans (of reorganization] were confirmed because they are, in effect, those of a new entity. Thus, comparative financial statements that straddle a confirmation date should not be presented.”21 should be noted that the AICPA statement is only applicable for companies emerging from a Chapter 11 proceeding where a fifty one percent ownership change occurs.

Thus, there appears to be a problem between state blue sky requirements and the AICPA However, federal bankruptcy law preempts” state law where Congress meant for federal law to control. Additionally, virtually all state security laws provide that state security statutes are preempted by relevant federal court order.”

Conclusion

The security exemptions under the Code were written into law by Congress with the express intent that a reorganizing debtor should not be burdened with strict adherence to federal or state security laws?’ A non-public company may literally “go public” by issuing debt or equity securities as a means of paying off bankruptcy claimants. Equity securities may include preferred and/or common shares, warrants, rights and options.

Additionally, the Code provides for the issuance of debt securities which may be converted into equity securities’ It is important to note that stock underlying warrants, rights and options is also exempt from registration?” Any entity that chooses to step in the “shoes” of the debtor by issuing its equity securities also falls under the same exemptions. In other words, a going concern, not in reorganization proceedings may bail out a Chapter 11 entity by proposing to acquire the reorganizing business simply by issuing its equity securities (which are exempt from registration) to bankruptcy claimants.

In sum, the exemptions granted under the Code were designed to increase the number of reorganizations by relaxing rigid state and federal security laws, rules and regulations while granting bankruptcy courts maximum flexibility to challenge companies to reorganize.

ENDNOTES

4′ Daniel J. Demers is a Chapter 11 Bankruptcy Reorganization Consultant. He is the author of many articles and publications including the book Bankruptcy, A Businessman’s Guide to Chapter 11 Reorganizations. Mr. Demers is the former Floor Loader of the Nevada State Assembly.

L. Paul Hudgins, Esq. practices law in Atlanta, Georgia with the law firm of Merritt & Tenney, LLP. He concentrates his practice in the areas of taxation, business transactions, corporations, and bankruptcy reorganizations.

Sidney J Diamond practices law in El Paso, Texas with the law firm of Sidney Diamond, PC . He concentrates his practice exclusively in the area of bankruptcy & tax law.

*** John Shurley, C.P.A. is a partner with Gifford, Hillegass Ingwersen, P.C., Certified Public Accountants. His practice is in two areas: audit and business consulting. He is a member of the American Institute of Certified Public Accountants and Georgia’s Society of C.P.A.’s, He is currently serving on the International Board of Directors and is Chairman of the Americas’ Region for ACM, International.

•1. Norton Bank, Code Pamph. § VA, 745 ( 1990-9I ed.).

•2. Id at 736.

3. Banks. Statistical Information prepared by Admin. Office of the U.S. Cts. (Washington, D.C. ; revised 1996).

•4. See e.g., In Re Mobile, LW, 97-37735-HCA-11 (B.C. N.D. Tx 1997) Plan of Reorganization confirmed January 8, 1998 ($240,000 in Debtor Certificates issued to creditors, and dissolution of LLC and conversion into C Corporation now called Advanced Wireless, Inc. Currently applying for OTC listing; In Re Warehouse Auto Centers, Inc., 95-21279 (B.C. W.D. NY 1995) Plan of Reorganization confirmed November 21, 1996 (SS million in Debtor Certificates issued to creditors, reverse split of shares, now trading as Newgold, Inc. (symbol NGLD on OTC)).

•5. See, Demers & Hudgins, Issuing Securities Through Chapter II Reorganizations, 8 Norton Healy. L. Advil. 6 (1995), and infra Note 25 for the issuance of securities while in bankruptcy reorganization.

6. S. Rep. No. 989, 95th Cons., 2d Sess. 114 (1978).
7. Norton supra Note 1, at 779.

S. 17 C.F.R, 270.201-1.

9. Demers, Hudgins & Diamond, 6 Norton Bankr. L. Advisor 6 (1998).
10. The responsibilities and functions of the Independent Auditor,

[I]s the expression of an opinion on the fairness with which they present, in all material respects, financial position, remits of operations and its cash flows in conformity with generally accepted accounting principle/ The auditor’s report la the medium through which he expresses his opinion or, if circumstances require, disclaims an opinion. In either case, he states whether his audit has been made in accordance with generally accepted auditing standards. These standards require him to state whether, in his opinion, the financial statements represented in conformity with generally accepted accounting principles and to identify those circumstances in which such principles have not been consistently observed in the preparation of financial statements of the current period in relation to Those of The preceding period. Statements on Auditing Standards (SAS) No. 1, section 110 (1997).

A compilation of financial statements is defined as “presenting in the form of financial statements information that is the representation of management (owners) without undertaking to express any assurance on the statement. Statements on Standards for Accounting and Review Services (SSARS)No. I (1997).

A review of financial statements is:

Performing an inquiry and analytical procedures that provide the accountant with a reasonable basis for expressing limited assurance that there are no material modifications that should be made to the statements in order for them to be in conformity with generally accepted accounting principles or, if applicable, with an other comprehensive basis of accounting.

The objective of a review differs significantly from the objective of a compilation. The inquiry and analytical procedures performed in a review should provide the

accountant with a reasonable basis for expressing limited assurance that there are not material modifications that should be made to the financial statements. No expression of assurance is contemplated in a compilation.

The objective of a review also differs significantly front the objective of an audit of financial statements in accordance with generally accepted auditing standards. The objective of an audit is to provide a reasonable basis for expressing an opinion regarding the financial statements taken as a whole. A review does not provide a basis for the expression of such an opinion because a review does not contemplate obtaining an understand of the internal control structure or assessing control risk, teats of accounting records and responses to inquiries by obtaining corroborating evidential matter through inspection, observation or confirmation, and certain other procedures ordinarily performed during an audit. A review may bring to the accountant’s attention significant

matters affecting the financial statements, but it does not provide assurance that the accountant will become aware of all significant matters that would be disclosed in an audit. Id.

•11. DEFINE OTC BULLETIN BOARD.

12. 17 C.F.R 240.12g-1, 12.1i-1.
13. 17 C.P.R. 240.15d-13.
14. 17 C.F.R. 240.154-1.
15. 17 C,F. R. 240.15d-11.
16. THE NASDAQ STOCK MARKET SUMMARY PACKET, Summary of Financial Requirements for Initial Listing, Fee Structure and Financial Requirements, September 1997. In addition to the Net Tangible Assets and minimum bid price, Nasdaq also requires the following for an initial listing on the SmallCap Market: (1) a public float of one million shares, (2) a minimum of three market makers, (3) at least three hundred shareholders holding a minimum of one hundred shares each, (4) an operating history of at least one year, (5) distribution of annual and Interim reports, (6) at least two independent directors, (7) an audit committee which must consist of a majority of independent directors, (8) an annual shareholders meeting, (9) a quorum requirement at the annual meeting of the shareholders, (10) solicitation of proxies, (11) a review of conflicts of interest, (12) shareholder approval for certain corporate actions, and (13) certain defined voting rights.

THE NASDAQ STOCK MARKET SUMMARY PACKET, Market Place Rules. September 1997.

17. Publication or Submission of Quotations Without Specified Information, S.E.C. Staff Release No. 34-39670; Pile No. S7-3-98 (February 17, 1995). Most bankruptcy professionals are in agreement that this attempted action by the Commission Is a violation of Congressional intent in enacting the Bankruptcy Code and an attempt at manipulating the Code by extrajudicial means. See, The Incongruities Between the Federal Securities Act and the U.S. Bankruptcy Code, Norton Ann. Survey of Bankr. L p.p. 195-219 (1994).
18. Commonly referred to as a Manual Listing.
19. Alabama, California, District of Columbia, Georgia, Illinois, Iowa, Kentucky, Louisiana, Missouri, Montana, New York, Pennsylvania, South Dakota, Tennessee, Vermont, Virginia and Wisconsin.
20. 11 § 1145 (a). “Subsection (a) exempt from the requirements of Section 5 of the Securities Act of 1933 and from any State or local law requiring registration or licensing of an Issuer of underwriter of or broker or dealer In, a security, the offer or sale of certain securities.” House and Senate Reports (Reform Act of 1978) as reported in Norton supra Note 1 at 922 (emphasis added].
21. AJCPA Tech. Prac. Aids, § 10 at 460 (Nov. 1990).
22. U.S. CONST. ART. VI, el. 2, SUPREMACY CLAUSE. See also, 11 U.S.C. §§ 1109, 1125, 1129, 1142, 1145, and 1146 stating or implying that no non-bankruptcy law, rule or regulation can preempt itself over the various security law exemptions granted under the Bankruptcy Code. Contra, 11 U.S.C. §§1126(b)(1) and 1129(2)(b).

•23. See Appendix.

•24. Supra Note 1.

25. 11 U.S.C. § 364. See also, Demers & Hudgins, Certificates of Indebtedness, 7 J. Bankr. L. & Prac. 185 (1998).
26. 11§ 1142(a).

State Statute

State Reference Statutory Exemption Statement

Alabama 8-6-11 (6) Any sale or offering for sale of any security at any judicial, executor’s, administrators, guardian or conservators sale, or at any sale by a receiver or trustee in insolvency or bankruptcy;

Alaska 45.55.140 (11) (b) A transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

Arizona 44-1844 (2) The sale of securities…by a receiver or trustee in . insolvency or bankruptcy approved by a court of competent jurisdiction of this state or the United Sates.

Arkansas 2342-504 (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

California 25102 (2) (k) Any offer or sale of any security under, or pursuant to a plan of reorganization under Chapter 11 of the federal bankruptcy law which has been confirmed or is subject to confirmation by the decree or order of a court of competent jurisdiction.

Colorado 11-15-113 (2) (f) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator,

Connecticut 36-490 (b) (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, creditors committee in a proceeding under the Bankruptcy Act, – guardian, or conservator;

Delaware 7309 (b) (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

D.C. 2-2801 (6) (C) Any transaction by a receiver or trustee in bankruptcy;

Florida 517.081 (1) At any judicial executors, administrators, guardian’s, or conservator’s sale, or at any sale by a receiver or trustee in insolvency or bankruptcy, or any transaction incident to a judicially approved reorganization in which a security is issued in exchange for one or more outstanding securities, claims, or property interests.

Georgia 10-5-9 (1) Any transaction by an executor, administrator, or guardian who is not an affiliate of the issuer of the security sold or offered for sale or by a sheriff, marshal, conservator, receiver or trustee in bankruptcy;

Hawaii 485-6 (6) Any transaction by a personal representative, sheriff, marshal!, receiver, trustee in bankruptcy, guardian, or conservator,

Idaho 30-1435 (5) Any transaction by an executor, administrator, sheriff, marshal!, receiver , trustee in bankruptcy, guardian, or. • conservator in the performance of his official duties as such;

Illinois 4[137.4] (F) Any offer or sale of securities by an executor, administrator guardian, receiver or trustee in insolvency or bankruptcy…

Indiana 23-2-1-2 (6) Any transaction by an executor, administrator, personal representative, sheriff, marshal, receiver trustee in bankruptcy, guardian, conservator, or anyone acting in a trust or fiduciary capacity where such transaction is effected pursuant to the authority of or subject to approval by any court of competent jurisdiction.

Iowa 502.203 (8) Any judicial sale or any transaction executed by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, custodian or conservator without any purpose of evading this chapter.

Kansas 17-1282 (e) Any transaction by an executor, administrator, personal representative, sheriff, marshal, receiver, trustee in bankruptcy, guardian or conservator or any transaction executed by a bona fide pledge without any purpose of evading this act.

Kentucky 292.410 (f) Any transaction by an executor, administrator. sheriff, marshal, receiver trustee in bankruptcy, guardian, or conservator;

Maine 10502 (2) (G) Any transaction by a personal representative, as defined in Title 18-A, Section 1-201, subsection 30, executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian or conservator acting in their official capacities;

Maryland 11-602 (6) Any transaction by a personal representative, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

Massachusetts 402 (b) (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator,

Michigan 451.802 (10) (b) (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

Minnesota 80A.15 Subd 2 (e) Any judicial sale, exchange, or issuance of securities made pursuant to an order of a court of competent jurisdiction.

Mississippi 75-71-203(6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator

Missouri 409.402 (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

Montana 30-10-105 (14) Any transaction incident to a right of conversion or a statutory or judicially approved reclassification, recapitalization reorganization, quasi-reorganization, stock split, reverse stock split, merger, consolidation, or sale of assets;

Nebraska 8-1111 (6) Any transaction by an executor, personal representative, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

Nevada 90.530 (8) Any transaction by an executor, administrator, sheriff, marshal’, receiver, trustee in bankruptcy, guardian, or conservator;

New Hampshire 421-6:17 II (e) Any judicial sale, exchange, or issuance of securities made pursuant to an order of a court of competent jurisdiction.

New Jersey 49;3-50 12(b)(6) Any transaction by an executor, administrator, sheriff, marshal’, receiver, trustee In bankruptcy, guardian, or conservator;

New Mexico 58-136-27 (H) A transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

New York 359-1 (I) Securities sold or offered for sale at any judicial, executors, administrator’s, guardian’s or conservator’s sale, or any sale by a receiver or trustee in insolvency or bankruptcy, or at any public sale by auction held at an advertised time and place.

North Carolina 78A-17 (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

North Dakota 10-04-06 (1) Any judicial, executors, administrators, guardian’s, or conservator’s sale or any sale by a receiver or trustee in insolvency or bankruptcy.

Ohio 1707.03 (C) The sale of securities by executors, administrators, receivers, trustees…and where such sales are subject to approval by, or are made in pursuance to authority granted by, any court of competent jurisdiction…

Oklahoma 401 (b) (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

Oregon 59.035 (1) Any transaction by a sheriff, marshal or court appointed fiduciary.

Pennsylvania 203 (k) Any judicial sale or transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian or conservator.

Rhode Island 7-11-9 (3) Any judicial sale, or the sale by…a receiver or trustee [n] insolvency or bankruptcy…

South Carolina 35-1-320 (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

South Dakota 47-31-84 The provisions of this chapter, except as here in expressly provided shall not apply to any judicial sale or the sale by an executor, administrator, receiver, guardian, or trustee appointed by the decree of any court.

Tennessee 48-2-103 (b) (1) Any transaction by a person acting as an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian Or conservator.

Texas 5 [581-5] (A) At any judicial, executor’s, administrators, guardian’s or conservator’s sale, or any sale by a receiver or trustee in insolvency or bankruptcy.

Utah 61-1-14 (2) (f) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

Vermont 4204(1) At any judicial, executor’s, administrators, or guardian’s sale, or at any sale by a receiver or trustee in insolvency or bankruptcy;

Virginia 13.1-514 (b) (6) Any transaction in his official capacity by a receiver, trustee in bankruptcy or other judicially appointed officer selling securities pursuant to court order;

Washington 21.20230 (6) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator;

West Virginia 32-4402 (b) (6) Any transaction by an executor, administrator, sheriff, marshal, constable, receiver, trustee in bankruptcy, guardian or conservator and any transaction constituting a judicial sale;

Wisconsin 551.23 (6) Any judicial sale or arty transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian or conservator.

Wyoming 17-4-114 (b) (vi) Any transaction by an executor, administrator, sheriff, marshal, receiver, Mishap h1 bankruptcy, guardian, or conservator;

Puerto Rico 882 (b) (8) Any transaction by an executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, or conservator,

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