Cramdown by the Non-Public Debtor


By Sidney J. Diamond, Esq.
El Paso, Texas

Participation by creditors in purchasing common stock, or other securities, pursuant to a plan of reor­ganization presents a new area of law for bankruptcy practitioners. A non-public corporate debtor does not have securities traded on either an exchange, or on the over-the-counter market. Its securities are usu­ally owned by a small number of individuals.


New value is the exception to the absolute priority rule discussed in Case v Los Angeles Lumber Prod­ucts Co., 308 US 106 (1939), which allows existing owners of a debtor to retain their equity by making a substantial contribution of new capital at cramdown in a Chapter 11 reorganization. It is not always obvi­ous or desirable that only insiders will be entitled to participate in “new value” purchase(s) when a non­public corporate debtor seeks to confirm a plan of reorganization by cramdown. The debtor who pro­poses a new value cramdown funded only by insiders is increasingly likely to face objections from credi­tors that the exclusion of others from participating in the new value purchase(s) (i) discriminates unfairly for purposes of 11 U.S.C. § I129(b)(1), (ii) is in fact a retention of property under the plan and therefore violates the absolute priority rule, or (iii) is not fair or equitable to creditors. The result may be that the debtor is required to open the door to others to par­ticipate in the new value purchase(s).

How does a debtor go about making offers to sell common stock or other equity or debt securities for cash or other value to the general creditor body? How does the debtor close the sale of such securities in a manner that complies with state and federal securi­ties laws?

The first question is whether a “safe harbor” exists under 11 U.S.C. § 1145 for such a transaction. The answer is no. The offer of securities for new value does not meet either test under 11 U.S.C. § 1145 be­cause it is not in exchange for a claim or interest or principally in exchange for a claim or interest. See Jet Florida Systems, Inc., SEC No-Action Letter, 1987 SEC No-Act LEXIS 1490 (December 12, 1986). It is hard to visualize a situation where a claim can be utilized to create a safe harbor under 11 U.S.C. § 1145 because in order for the “deal” to be fair it must be the same offer made to the insiders who do not hold claims on the same parity as general creditors.

To determine what alternatives to Al U.S.C. § 1145 are available one must first examine whether the trans­action contemplated by the plan is a regulated trans­action, and if so by whom. The federal definition of a security in 15 U.S.C. § 77b is pervasive. The defi­nition of a security under state “Blue Sky Laws” is typically as pervasive. Common stock is a security under both federal and state law as well as almost any other type of debt or equity instrument that might be used by a corporate debtor in a plan of reorganiza­tion. 15 U.S.C. § 77r gives the states concurrent ju­risdiction over the regulation of securities. The result is that debtors issuing stock for “new value” must com­ply with federal securities law and the laws of any state in which an offer or sale is made.

While the thought of dealing with the laws of many individual states is cause for concern, securities law­yers do so all of the time without great difficulty. Several publishers offer collections of the applicable state laws.

Having determined that a proposed sale of new securities to creditors is subject to both federal and state law the next step is to determine what those laws require and how those requirements are modified by Title 11. 15 U.S.C. § 77e sets forth who must file a registration statement. The Blue Sky Laws of the sev­eral states contain similar provisions. Both laws re­quire that a registration statement be in effect at the time of an offer or sale, unless excused. Section 77e says it is “unlawful” to carry out a transaction unless a registration statement is in effect. Most state law is the same. For a company to sell common stock in the open market it must have a registration statement with the Securities and Exchange Commission, the state of the company’s domicile and each state in which a sales effort is made. The failure to file a registration statement or have a valid exemption risks civil sanc­tions and damages and criminal liability.

Exemption from the registration process under fed­eral law is contained in 15 U.S.C. § 77d. Most Blue Sky Laws contain similar exemptions. These exemp­tions are very seldom used because of the adoption of Regulation D by the Securities and Exchange Com­mission pursuant to its rule-making authority. Regu­lation D created a safe harbor for the “private placement of securities” that were not being regis­tered. All of the states either changed their statutes to conform to the new regulation or adopted regulations to the same effect. Unfortunately, Regulation D is not available for the type of transaction contemplated here-if for no other reason because it would be im­possible to determine the number of “non-accredited offerees” before making an offer for sale.

As an alternative to Regulation D, debtors might utilize the original private placement exemption pur­suant to 15 U.S.C. § 77d(2), and corresponding state statutes or regulations which were carried forward into Regulation D. The intent of carrying forward 15 U.S.C. § 77d(2) into Regulation D was to create a safety valve in the event that one or more of the re­quirements under Regulation D were unsatisfied. A general statement of this exemption from the regis­tration provisions is that it is an offer for sale and/or sale, without any public solicitation or advertising to a limited number of sophisticated investors who pur­chase the securities for investment purposes without a view to further distribution.

While there is no specific requirement of an offer­ing document to effect a private placement of securities exempt from registration under 15 U.S.C. § 77d(2) one is almost always used to document the information conveyed to a prospective purchaser. The Chapter 11 disclosure statement can serve this pur­pose easily with a little alteration and provide a mea­sure of protection because the information required to be imparted to creditors/investors is determined by the court. 11 U.S.C. § 1125(d) provides that the court will determine what is adequate information, although a regulator may appear and present the position of the Securities and Exchange Commission or any appli­cable Blue Sky Law. 11 U.S.C. § 1125(e) protects participants who solicit and sell securities, provided they have proceeded in good faith. While § 1125(e) does not provide the same global safe harbor that 11 U.S.C. § 1145 provides, it does provide a substantial measure of protection with respect to the disclosure.

The greater the number of creditors to whom an offer for sale is made the less likely that the original private placement exemption from the registration provisions will be available. One possible solution would be to limit the number of creditors receiving such an offer by restricting the offer to creditors hold­ing claims of a certain size or character. Such a re­striction may be discriminatory pursuant to the provisions of 11 U.S.C. § 1129(b)(1).

One remaining question is what additional infor­mation is required by securities considerations to be included in a disclosure statement, especially in light of II U.S.C. § 1125(d) that excludes any non-bank­ruptcy law, rule, or regulation in determining what is adequate information. Courts can be expected to ad­dress that issue at the disclosure statement hearing. It would not be surprising for courts to conclude not­withstanding an exemption from registration, that it is still incumbent on the debtor to furnish most of the same general information to prospective creditors/ purchasers that such purchasers would have received had a registration statement been required. It is not suggested that securities guidelines be adopted whole­sale into the disclosure statement requirements; rather it is suggested that those guidelines are a place from which a court might select disclosure information.

To satisfy 15 U.S.C. § 77d, certain representations must be made by the buyer including that the buyer is purchasing for his/her own account only and that the purchase is being made for investment purposes only and not with a view to the distribution of the securi­ties offered. The first representation prevents hidden partnerships from participating in the offering which could have the effect of making the exemption un­available because of the number of purchasers.

The private placement exemption calls for sales to be made to only highly sophisticated investors. This is established through an offeree questionnaire that inquires about the relative wealth and experience of the investor. When an offer is made to creditors can the debtor inquire about wealth and experience and reject a prospective purchaser on that basis? To main­tain the registration exemption the debtor is compelled to make such inquiries and if appropriate reject an unqualified purchaser. Further, the debtor must care­fully count the number of offerees and purchasers.

Additionally, a restrictive legend should be placed upon the securities issued by the debtor. Such a re­striction constitutes a “stop transfer” on the securi­ties.

In summary, it is unfortunate that II U.S.C. § 1145 does not provide a comprehensive safe harbor for debtors that issue securities to creditors at cramdown in a Chapter 11 case. Although the private offering exemption under federal law, Regulation D, is not available, compliance may be achieved through the initial private offering exemption under 15 U.S.C. § 77d(2). If the debtor proceeds in good faith, a lim­ited safe harbor becomes available pursuant to 11 U.S.C. § 1125(e).

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