CRAMDOWN BY THE NON-PUBLIC CORPORATE DEBTOR, NEW VALUE AND THE SECURITIES LAWS
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.
NORTON BANKRUPTCY LAW ADVISER
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).