Liquidity, Disclosure and their Enemies:
Securities Issues and Trading Freezes in Chapter 11
By Thomas Moers Mayer
Partner, Kramer Levin Naftalis
& Frankel LLP
919 Third Avenue
New York, New York 10022
212-715-9169
Tmayer@kramerlevin.com
Submitted to the American College of Bankruptcy
Committee on Best Practices in Connection with
the Disclosure of Information in Chapter 11
June 2004
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Liquidity, Disclosure and their Enemies:
Securities Issues and Trading Freezes in Chapter 11
By Thomas Moers Mayer1
Claims trading is an integral part of every major chapter 11 case. Trading creates
liquidity. Liquidity demands disclosure. Both present issues in chapter 11 – disclosure
because the law is changing, and liquidity because courts and counsel too often ignore its
value to creditors.
Part I of this Paper shows that liquidity and disclosure must be an integral part of
every major chapter 11, and examines the motives of the numerous parties who seek to
eliminate disclosure and chill liquidity. Part II describes the law of disclosure in chapter
11, and examines the additional requirements of the SEC’s new Regulation FD. Part III
of this Paper describes how claims trading can impair the value of certain debtor tax
attributes known as “net operating loss carryforwards” (“NOLs”). Debtors have obtained
injunctions against claims trading to preserve the value of their NOLs, but Part III of this
Paper shows that those injunctions are rarely if ever justified: The value of the NOLs
preserved will rarely if ever exceed the price paid by all creditors in the loss of liquidity.
1
Thomas Moers Mayer is a partner in the bankruptcy department of Kramer Levin Naftalis & Frankel LLP.
The author wishes to thank Cynthia Mann and Mary Jo Brady, his colleagues in Kramer Levin’s tax
department, for their essential guidance, counsel and advice in connection with Part III of this paper, which
contains analysis they do not necessarily endorse. The author also wishes to thank Kenneth Eckstein,
Philip Bentley, Robert Schmidt, Abbe Dienstag, James McCarroll, Brian Hagerty, Santo Cipolla, Rachel
Morrissey and Sheldon Snaggs, his colleagues in Kramer Levin’s bankruptcy and corporate departments,
for their counsel and assistance in connection with the other parts of this paper.
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I.
Claims Trading and its Enemies.
A. The Inevitability and Necessity of Claims Trading.
There is a fundamental difference between the United States and the rest of the
world in the handling of major corporate insolvencies. The rest of the world assumes
that large financially distressed companies will, most of the time, sell their assets to new
buyers. Stakeholders (i.e., creditors and shareholders) will share in the sale proceeds.
They will no longer hold an interest in the business. The decision to receive cash is made
by the law.
By contrast, the United States assumes that, most of the time, large financially
distressed companies will reorganize their balance sheets by converting debt to equity.
The company’s stakeholders will receive new securities issued by the reorganized
company. Accordingly, stakeholders retain some interest in the insolvent business unless
they decide to sell their claims and stock. The decision to receive cash, not securities, is
made by each stakeholder, not by the law.
The conversion of debt to equity requires both liquidity and disclosure.
First, liquidity: If a multitude of creditors is to receive equity, the equity must be
liquid or else it will be of little value to its recipients. The holder of a debt instrument is
promised principal and interest, and needs only the right to sue to obtain the promised
value. By contrast, the holder of a minority equity interest has virtually no ability to
obtain cash for its equity, except by selling it. Liquidity also provides fairness to the
reorganization process. Those creditors who do not want securities may sell their
securities (or their claims) for cash. Those creditors who are prepared to accept securities
can retain them, or even buy from the sellers. Most of my clients are funds that buy
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claims against corporations in financial distress. I believe a basic justification for the
existence of such funds is that they, as claims buyers, are more prepared to take
securities, and in particular equity, than are the claims sellers. Although not all of my
clients share this belief (like every creditor, they often prefer cash and debt to stock), it
almost has to be true. The commercial banks and insurance companies who sell claims
have regulatory and accounting constraints on their ability to hold equity; the funds that
buy claims do not.
Second, disclosure: Liquidity may be essential to the value of equity, but no
market will develop for equity (or any security) if information about the issuer is not
available:
Full and fair disclosure of information by issuers of securities to the investing
public is a cornerstone of the federal securities laws. In enacting the mandatory
disclosure system of the [Securities] Exchange Act, Congress sought to promote
disclosure of “honest, complete and correct information” to facilitate the
operation of fair and efficient markets.2
In sum, without liquidity the debtor’s securities have less value; without
disclosure there is no liquidity, and thus less value. I hold these truths to be self evident,
but they have remarkably little currency among many actors in a chapter 11 case. The
truth is that many of the participants in a chapter 11 case wish there were no disclosure,
and distrust the market.3
2
SEC Release Nos. 33-7787, 34-42259, IC-24209, File No. S7-31-99, 64 F.R. 72590 (Dec. 20, 1999), text
at notes 7 & 8, quoting S. Rep. No. 73-1455 at 68 (1934) and citing H.R. Rep. 73-1383, at 11 (1934) and S.
Rep. No. 73-1455 at 10-11, 19-20 (1934).
See “Chapter 22: Are vulture investors to blame?” as “Is it possible to uproot the insider trading weed
without killing the distressed debt market”?, both published in 38 Bankruptcy Court Decisions Weekly
News & Comment No. 4 (Aug. 21, 2001).
3
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3
B. The Enemies.
Take first the debtor. The debtor is run by management who focuses (properly)
on the operation of the business. The more profitable the business, the more valuable the
business and (ultimately) the more valuable its securities. The more information the
business must disclose, the more aid it provides to its competitors, and the more time and
energy management must spend on disclosure rather than operations. Prior to chapter 11,
managers with stock options have a stake in a liquid market, because the market will
allow them to cash out their in-the-money options. In chapter 11, however, stock options
are usually worthless. Management no longer has a stake in the existence of a liquid
market. Indeed, management may regard the market as either bad or dangerous: Bad
when the price of claims trends down, since that reflects a critical judgment on
management’s performance, and dangerous when the price of claims trends up, since the
creditors, as eventual holders of the company’s equity, will be displeased with
management if the securities of the reorganized debtor do not provide the value predicted
by the claims trading market.
There are some debtors who reflexively refuse to disclose information. In the
chapter 11 reorganization of Woodward & Lothrop, Inc., the debtor refused to provide its
bondholders unrestricted access to annual financial statements on the grounds that they
were “confidential,” even though prior to chapter 11 the bond indenture had required
public distribution of those statements.
Take next the unsecured creditors’ committee. Service on a creditors’ committee
often takes a lot of time. Committee members are not paid for their service. Their
principal compensation is access to more information (and some greater degree of
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influence over the debtor, the plan of reorganization and the case) than creditors not on
the committee. The only reason a committee member would want widespread disclosure
of information is to help that committee member sell its claim. Committee members who
plan to retain their claims and serve on the committee for the entire case have every
incentive to discourage disclosure of information. They have no reason to encourage the
claims trading market, which -- fairly or unfairly -- passes judgment on them as well as
the debtor.
The market also allows one or more parties who are not on the committee to
accumulate large blocks of claims, which reduces the committee’s influence.4
Sometimes the institutions that acquire large amounts of claims clash with a committee
whose members hold small amounts of claims. In these situations, the Committee’s
blessing on a plan means less when it comes to a vote.
Finally, committees may contain trade creditors whose own goals for the debtor
are fundamentally inconsistent with the market. Assume that a trade creditor holds a
claim against the debtor that is small in relation to that creditor’s total accounts
receivable. The trade creditor has sold to the debtor, and continues to sell to the debtor,
goods at a 50% mark-up. It makes no sense for the trade creditor to serve on a creditors’
committee unless the trade creditor is on the committee to facilitate future sales to the
debtor. The trade creditor’s profit on future sales will more than make up for the loss on
the claim. That trade creditor may have no interest in the market for claims and little
4
It has become commonplace for Chapter 11 plans to be negotiated primarily by claims buyers who hold
dominant positions in the case and who do not serve on the Committee, e.g., Insilco, National Gypsum,
Macy’s, Barney’s and Morris Materials. This does not, however, mean that most claims buyers seek a
dominant position in the case. In fact, most claims buyers are passive investors, having neither the capital,
the managerial resources, nor the inclination to pay lawyers necessary to exercise influence on the case.
Those who think differently, e.g. Tung, Confirmation and Claims Trading, 90 NW. U.L. REV. 1684 (1996),
describe (without factual support) a trading market with which the author is unfamiliar.
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interest in the eventual recovery of unsecured creditors. Yet such trade creditors are
frequently nominated to creditors’ committees – undoubtedly because the debtor needs
the support of the trade. Bankruptcy courts have acknowledged the necessity of trade
support by approving ever-larger “doctrine of emergency” payments to ever broader
categories of “essential” trade creditors. Congress is about to ratify the courts’ preference
of trade over other unsecured creditors by making pre-petition trade claims
administrative expenses.5 The United States Trustees act consistently when they appoint,
as members of creditors’ committees, trade creditors whose interest lies more in profiting
from post-bankruptcy sales than in maximizing recovery on claims for the prebankruptcy sales.
The committee has professionals. The professionals are usually chosen by the
committee’s original members. The existence of a market tempts these original members
to sell their claims and resign, to be replaced by new committee members who may be
less friendly to committee professionals, and less committed to their continued retention.
The basic problem for all these parties is that the market threatens the community
of insiders and professionals who negotiate deals in chapter 11.6 Sometimes that
community is productive; sometimes it is overly cozy.7
5
H.R. 333, 107th Cong. 1st Sess. § 1227(b) (2001); S. 420, 107 th Cong., 1st Sess. § 1227(b) (2001).
6
See “Chapter 11: Are vulture investors to blame?” , supra n. 2, at A1 (turnaround manager Deborah
Hicks Midanek: “It can be so distracting to a company to have a bunch of new people around the table
every time they try to negotiate a plan”).
7
See In re Bidermann Indus. U.S.A., Inc., 203 B.R. 547 (Bankr. S.D.N.Y. 1997). In Bidermann, the
debtor’s turnaround manager negotiated a deal with the creditors’ committee to buy the debtor for himself.
Claims buyers broke up this sweetheart deal:
The debtors and the [committee] attempt to turn this dispute around to an attack on the motives of the
objectants, who, they say, are simply trying to obtain more than the windfall which they will already
be receiving for the claims which they acquired at a discount. There is, however, nothing inherently
improper about purchasing claims at a discount. There is something to be said, in contrast, about the
liquidity given to creditors through the existence of a secondary market for their claims. In any event,
the motives of the objectants cannot justify what management seeks to accomplish here. . . . There is
manifest self-dealing here. . . . the bottom line is that [the managers] have done little to ensure the
integrity of this process because they are activated by the possibility of personal gain. . . . I am
obliged to ensure that the creditors are not made pawns to the professionals.”
Id. at 552 -54.
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In sum, the cast of characters in a chapter 11 case is often filled with persons with
no reason to like the market or disclosure of information. They usually attack the market
by complaining about “trading on inside information.”8 However, after studying more
than one hundred years’ reported cases on claims trading, I have found no decision
reporting any buyer or seller objecting, in a bankruptcy case, to any trade made on inside
information. Allegations of “insider trading” in chapter 11 almost always come from
debtors and others who have no standing to complain, and they never cite any example of
an injured buyer or seller.
II. The Law of Disclosure in Chapter 11.
A. Law Through 2000.
We start with the securities laws – because almost all major insolvent
corporations have publicly traded securities, or will have publicly traded securities
coming out of chapter 11.
If a corporation has –
 securities listed on a national securities exchange,
 securities traded over the counter and registered under section 12(g) of the
Securities Exchange Act of 1934 (the ’34 Act”), or
 a registration statement that has become effective under the Securities Act of
1933 (the “’33 Act””),
it must file annual reports on form 10-K, quarterly reports on form 10-Q, and reports of
material events on form 8-K.
If an issuer determines that its securities are held by fewer than 300 American
holders, and it is current in its ’34 Act filings, it can “deregister” its securities by filing a
8
“Is it possible to uproot the insider trading weed without killing the distressed debt market”, supra n. 2.
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Form 15 under Rule 12h-3 of the ’34 Act.9 Then disclosure requirements become
considerably murkier. If the securities were issued under a trust indenture, the indenture
may require the issuer to file with the indenture trustee (for inspection by bondholders)
annual and quarterly reports similar to 10-Ks and 10-Qs. However, if the securities are
in default under other covenants, there is no reason for the issuer to comply with the
indenture’s reporting covenants, and issuers often ignore them.
The ’34 Act and the SEC’s rules provide for some flexibility for issuers in chapter
11. For example, section 12(h) of the ‘34 Act10 permits the SEC to exempt issuers in
whole or in part from the reporting requirements of the Exchange Act,
if the Commission finds by reason of the number of public investors, amount of
trading interest in the securities, the nature and extent of the activities of the
issuer, income or assets of the issuer or otherwise, that such action is not
inconsistent with the public interest or the protection of investors.
Exchange Act Rule 12b-2111 further provides that “if any required information is
unknown and not reasonably available to the registrant . . . because the obtaining thereof
would involve unreasonable effort or expense, . . . the information may be omitted [and]
such information as the subject [the issuer] possesses or can acquire without unreasonable
effort or expense, together with the sources thereof” may instead be provided.
The filing of a chapter 11 petition does not relieve the debtor of its reporting
obligations under the ’34 Act.12 However, chapter 11 companies are subject to other
9
17 C.F.R. § 240.12h-3. The rule sets forth other criteria for deregistration, not relevant here.
10
15 U.S.C. § 78i.
11
17 C.F.R., § 240.12b-21.
12
SEC Staff Legal Bulletin No. 2 (CF) (April 15, 1997), available at www.sec.gov.interps/legal/sbcf.2.
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disclosure requirements under Code § 704, which provides that the trustee (and thus the
debtor-in-possession):13
shall –
(7) unless the court orders otherwise, furnish such information
concerning the estate and the estate’s administration as is required by a
party in interest;14 [and]
(8) if the business of the debtor is authorized to be operated, file
with the court [and] with the United States trustee . . . periodic reports and
summaries of the operation of such business, including a statement of
receipts and disbursements, and such other information as the United
States trustee or the court requires. . . .
Bankruptcy Rule 2015 further provides, in relevant part, as follows:
(a) Trustee or Debtor in Possession. A trustee or debtor in possession
shall:
*
*
*
(2) keep a record of receipts and the disposition of money and
property received;
(3) file the reports and summaries required by § 704(8) of the
Code . . .
*
*
*
(5) in a chapter 11 reorganization case, on or before the last day of
the month after each calendar quarter until a plan is confirmed or the case
is converted or dismissed, file and transmit to the United States trustee a
statement of disbursements made during such calendar quarter . . .
*
*
*
(d) Transmission of Reports. In a chapter 11 case the court may direct
that copies or summaries of annual reports and copies or summaries of other
reports shall be mailed to the creditors, equity security holders and indenture
trustees. The court may also direct the publication of summaries of any such
reports.
13
Bankruptcy Code § 1107(a)(1) provides that a debtor-in-possession has the duties of chapter 11 trustee
set forth in 11 U.S.C. § 1106(a)(1), which includes “the duties of a trustee specified in sections . . . 704(7)
[and] 704(8) . . . .”
Research has discovered no published opinion on any party’s attempt to use § 704(7) to obtain
disclosure of information. However, there is no reason why it could not be so used.
14
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The U.S. Trustees in various districts have adopted guidelines and forms for
chapter 11 debtors to use in complying with Code § 704(8) and Rule 2015. These
guidelines and forms are always referred to as “Operating Guidelines and Financial
Reporting Requirements.” They have not been published in the Federal Register and
appear in no official publication, but are provided by the U.S. Trustee’s Office in each
region. Region 3, which includes Delaware, provides a handout including a form of
“Initial Monthly Operating Report” to be filed with the Court within 15 days of the
commencement of the case, and a form of “Monthly Operating Report” to be filed within
20 days after the end of each month. The Initial Monthly Operating Report must include
a 12-month cash flow projection. The Monthly Operating Report includes a schedule of
cash receipts and disbursements, a statement of operations and a balance sheet, plus a
statement of accounts receivable aging. This report, in some ways, requires information
more detailed than that which is required by forms 10-K and 10-Q.15 Outside of
bankruptcy, issuers are not generally required to provide financial information on a
monthly basis, or a 12-month cash flow forecast.16
In fact, so much information is required under the Bankruptcy Code and Rules
that the SEC has adopted the policy of issuing “no action letters” relieving chapter 11
debtors of their ’34 Act reporting requirements so long as they meet the criteria set forth
in Staff Legal Bulletin No. 2,17 which may be summarized as follows:
15
See Campo Elects., Appliances and Computers, Inc., 1998 SEC No-Act. LEXIS 1054 (Nov. 2, 1994)
(The Trustee’s Reports will be presented more frequently than is required by the Exchange Act for Forms
10K and 10Q, and will contain information not normally contained in those forms).
The US Trustee’s Office for the Southern District of New York requires similar disclosure, including an
“Operating Report, consisting of a Statement of Operations and Balance Sheet prepared in accordance with
generally accepted accounting principles.” All reports are to comply with the standards of AICPA
Accounting Principles Board Opinion #28, FASB 95 regarding Statement of Cash Flow, and AICPA
Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code.
16
17
SEC Staff Legal Bulletin No. 2 (CF) (April 15, 1997), available at www.sec.gov.interps/legal/sbcf.2.
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 Fulfillment of ‘34 Act reporting requirements prior to filing;
 Prompt disclosure of the bankruptcy filing on Form 8-K;
 Whether the issuer is able to continue ‘34 Act reporting and whether the
information in other reports filed by the issuer is adequate to protect investors;
 Little or no trading in the issuer’s securities;18 and
 Whether the request for approval of modified reporting is filed with the SEC
promptly after the bankruptcy filing.19
If the issuer meets the criteria to the SEC’s satisfaction, the Division of Corporate
Finance will generally accept, instead of Form 10-K and 10-Q filings, the issuer’s
monthly operating reports filed with the Bankruptcy Court pursuant to Rule 2015. Each
report must be filed on Form 8-K within 15 calendar days after the monthly operating
report is due to be filed. Corporations reorganizing under chapter 11 must disclose any
material event relating to the reorganization in an 8-K. Corporations liquidating in
chapter 11 must disclose on form 8-K whether any liquidation payments will be made to
security holders, the amount of any liquidation payments, the amount of any expenses
incurred and any other material events relating to the liquidation. If a plan is confirmed,
the issuer must file a form 8-K, which “should include the issuer’s audited balance
sheet.” Staff Legal Bulletin No. 2 continues:
Any post-reorganization filings under the Securities Act or the Exchange Act
must include audited financial statements prepared in accordance with generally
accepted accounting principles for all periods for which audited financial
18
Staff Legal Bulletin No. 2 literally requires only information as to the volume of trading, but any
noticeable amount of trading has been sufficient for the SEC to deny no-action requests. See USA Biomass
Corp., 2001 SEC No-Act LEXIS 528 (April 19, 2001) ([T]he Division is unable to provide the requested
no-action relief. . . . We note, among other things, the volume of trading in the Company’s securities. . .”;
request had noted de-listing from NASDAQ of common stock and 13-month trading volume of 406,800
shares with a dollar volume of $107,676). Compare Atlantic City Boardwalk Assocs., L.P., 2000 SEC NoAct LEXIS 320, at *1 (March 9, 2000) (granting no-action request, noting the representation that “there is
no trading in the Partnership’s securities”).
19
Concord Energy Inc., 1998 SEC No-Act. LEXIS 1056 (Dec. 17, 1998) (denying request for no-action
letter, made 76 days after filing, as untimely); Vectra Techs., Inc., 1998 SEC No-Act. LEXIS 536 (request
dated 172 days after filing was untimely).
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statements are required even though the issuer may have been subject to
bankruptcy proceedings during some portion of those periods.20
The requirement of audited financial statements for the time spent in chapter 11 is
not, in fact, consistent with Bankruptcy Code § 1125(d), which expressly provides that
whether a disclosure statement contains “adequate information” is not governed “by any
otherwise applicable non-bankruptcy law, rule or regulation.” The legislative history of
§ 1125 states that the SEC’s standards for disclosure were not to apply to the disclosure
statement:
Reporting and audit standards devised for solvent and continuing businesses do
not necessarily fit a debtor in reorganization. Subsection (a)(1) expressly
incorporates consideration of the nature and history of the debtor and the
condition of its books and records into the determination of what is reasonably
practicable to supply.21
Subsection (d) excepts the disclosure statements from the requirements of the
securities laws (such as section 14 of the 1934 Act and section 5 of the Securities
Act . . .).22
It makes no sense to exempt a disclosure statement from the ’34 Act’s requirement of
audited financials only to have the SEC insist on audited financials being filed 15 days
after plan consummation. For most large corporate debtors, however, the point is
academic: Any debtor-in-possession lender will have required such debtors to provide
audited financial statements, so that filing such statements after plan consummation
should pose little or no difficulty.
More disclosure requirements may be on the way. As of this writing, the
bankruptcy reform bills passed by both the House of Representatives and the Senate
contain provisions increasing the amount of disclosure required in chapter 11 cases. Both
20
Id., text at notes 23-24.
21
S. REP. NO. 95-989, 95TH CONG. 2D SESS. 120 (1978)
22
H. REP. NO. 95-595, 95TH CONG. 1ST SESS. 408 (1977).
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bills amend § 1102 to increase the duties of creditors’ committees to include providing
access to information:
(3) A committee appointed under subsection (a) shall -(A) provide access to information for creditors who-(i) hold claims of the kind represented by that committee; and
(ii) are not appointed to the committee;
(B) solicit and receive comments from the creditors described in
subparagraph (A) and
(C) be subject to a court order that compels any additional report or
disclosure to be made to the creditors described in subparagraph (A). 23
Section 419 of Senate Bill 420 directs the Advisory Committee on the Bankruptcy
Rules to propose rules and forms requiring debtors to disclose the “value, operations, and
profitability of any closely held corporation, partnership or other entity in which the
debtor holds a substantial or controlling interest.” If such rules are adopted, debtors will
be forced to file publicly consolidating financial statements -- information which is
routinely required by bank lending groups, but which the SEC has never required issuers
to provide to the investing public.
B. Developments in Disclosure – Regulation FD.
On December 20, 1999, the Securities and Exchange Commission proposed new
rules, including a rule called “Regulation FD.” Regulation FD would require “fair
disclosure” of material non-public information.24 After receiving over 6,000 comments,
the SEC promulgated Regulation FD as a final rule, taking effect on October 23, 2000.
Regulation FD was prompted by the boom market in technology stocks, the rise
of day trading, and the belief of thousands of individuals that many companies routinely
23
H.R. 333, 107th Cong. 1st Sess. § 405(b) (2001); S. 420, 107th Cong., 1st Sess. § 405(b) (2001). It is not
clear why this paragraph was added to § 1102, which deals with the appointment of Committees, instead of
§ 1103, which sets out their duties. And no, I don’t know what subparagraph (C) means or why it is there.
The House and Senate Reports contain no guidance.
24
Exchange Act Release No. 42259 (December 20, 1999), 64 FR 72590.
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gave certain analysts, major broker dealers and institutional investors previews of
material non-public information. Such previews gave the favored recipients an
“unerodable” information advantage over the ordinary investor. This unquestionably was
the case. Prior to the adoption of Regulation FD, it was common for professional
investors to seek “whisper numbers” – advance news of unannounced earnings and other
financial results for the quarter in progress or the quarter just ended.25
The SEC moved to remedy this situation in Regulation FD by requiring
simultaneous or near simultaneous disclosure of material information. Regulation FD
may be set forth (in somewhat abbreviated fashion), as follows:
17 C.F.R. § 243.100 General Rule
(a)
Whenever an issuer, or any person acting on its behalf, discloses
any material nonpublic information regarding that issuer or its securities to any
person described in paragraph (b)(1) of this section, the issuer shall make public
disclosure of that information as provided in § 243.101(e):
(1) simultaneously, in the case of an intentional disclosure; and
(2) Promptly, in the case of a non-intentional disclosure.
(b)(1) Except as provided in paragraph (b)(2) of this
section, paragraph (a) of the section shall apply to a disclosure
made to any person outside the issuer:
(i) Who is a broker or dealer, or a person associated with a
broker or dealer26 . . . (ii) . . . an investment adviser, . . . an
institutional investment manager . . .that filed a report on
Form 13F . . .for the most recent quarter ended prior to the
date of the disclosure; or a person associated with either of
the foregoing; (iii) . . . an investment company, . . . or an
affiliated person of either of the foregoing. For purposes of
this paragraph; or (iv) . . . a holder of the issuer’s securities,
under circumstances in which it is reasonably foreseeable
that the person will purchase or sell the issuer’s securities
on the basis of the information.
Peter Edmonston, “Shhh! Focus on ‘Whisper Numbers’ Fades As Pundits Sidestep the Informal
Targets,” Wall St. J., July 26, 2001.
25
The ellipses contain FD’s cross-references to definitions of “broker”, “dealer”, “associated”, etc. set forth
in the ’34 Act, the Investment Advisers Act of 1940 (15 U.S.C. § 80b-2) and the Investment Company Act
of 1940, (15 U.S.C. § 80a-2). The breadth of the definitions is beyond the scope of this paper.
26
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(2) Paragraph (a) of this section shall not apply to a
disclosure made: (i) To a person who owes a duty of trust
or confidence to the issuer (such as an attorney, investment
banker, or accountant); (ii) To a person who expressly
agrees to maintain the disclosed information in confidence;
(iii) To a [rating agency]; or (iv) In connection with a
securities offering registered under the Securities Act . . .
(c) Person acting on behalf of an issuer. “Person acting on
behalf of an issuer” means any senior official of the issuer
(or, in the case of a closed-end investment company, a
senior official of the issuer’s investment adviser), or any
other officer, employee, or agent of an issuer who regularly
communicates with any person described in [¶(b) above].
An officer, director, employee or agent of an issuer who
discloses material nonpublic information in breach of a
duty of trust or confidence to the issuer shall not be
considered to be acting on behalf of the issuer.
*
*
*
(f) Senior official. “Senior official” means any director,
executive officer (as defined in § 240.3b-7 of this chapter),
investor relations or public relations officer, or other person
with similar functions.
I have not reviewed the 6,000 comment letters, but I venture to guess that
neither the commentors nor the SEC gave much thought to how this regulation would
work in connection with bankruptcy cases.
To take only the most obvious example, Regulation FD exempts from its
scope securities offerings registered under the Securities Act. No similar exemption is
made for the issuance of securities under a bankruptcy plan, which are deemed by
Bankruptcy Code § 1145 to be issued in a public offering. Applying Regulation FD to
bankruptcy plan disclosures may not make sense. The bankruptcy judge is supposed to
approve the disclosure statement as containing “adequate” information, which is a
different standard than “all material information.” Once the bankruptcy court approves
the disclosure statement, solicitation of votes using the disclosure statement is protected
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by the safe harbor provision of § 1125(e). If Regulation FD requires a subsequent
disclosure of, say, a court filing (see below), will that disclosure be covered by
§ 1125(e)?
Even those debtors who abhor disclosure of any information must routine
go to court – to borrow money, to use cash collateral, to sell property, to assume
contracts, to extend the time to assume or reject leases, or to extent the period in which
only the debtor can file a plan of reorganization. Every time the debtor seeks relief, it
files a pleading in the public record. Every time the debtor goes to court, it enters
evidence on the record. Public access to the record is governed by Bankruptcy Code §
107:
§ 107. Public access to papers.
(a)
Except as provided in subsection (b) of this section, a paper filed in
a case under this title and the dockets of a bankruptcy court are public records and
open to examination by an entity at reasonable times without charge.
(b)
On request of a party in interest, the bankruptcy court shall, and on
the bankruptcy court’s own motion, the bankruptcy court may -(1) protect an entity with respect to a trade secret or confidential
research, development or commercial information; or
(2) protect a person with respect to scandalous or defamatory
matter contained in a paper filed in a case under this title.
Section 107(b) provides broader grounds for sealing a record than the Federal Rules of
Civil Procedure,27 and has been used to seal, among other things, those pages of an
opposition to the extension of exclusivity that contained details of the debtor’s previously
confidential plan proposal.28 Nonetheless, the presumption is that papers filed in
27
In re Lomas Fin. Corp., No. 90 Civ. 7827, 1991 U.S. Dist. LEXIS 1589 (S.D.N.Y. Feb. 11, 1991)
(“Lomas”); In re Matter of Moses, 171 B.R. 789 (Bankr. E.D. Mich. 1994).
28
Lomas, supra n. 15.
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bankruptcy court are open to public inspection,29 in part because of “the nature of the
bankruptcy process -- which is heavily dependent upon creditor participation, and which
requires full disclosure of debtor’s affairs.”30
Prior to Regulation FD, few debtors would have given any thought to “disclosure”
of their court filings. After Regulation FD, debtors have to do so.
It is true that Regulation FD only covers communications with investment
advisers, broker dealers, investment companies and other individuals listed in Regulation
FD’s subparagraph (b)(1). (I refer to these individuals as “investment professionals”.)
But investment professionals call debtors all the time for information. If an investment
professional asks for information that the debtor knows will be disclosed in a pleading, is
the debtor obligated to file the pleading in an 8-K at the same time as it files the pleading
in court?
Note that the SEC amended its proposed regulation to make final Regulation FD
apply only to issuers who know (or would be reckless in not knowing) that disclosed
information was material. Note also that this distinction may not help. If an investment
professional calls and asks for information that will be contained in a pleading, the debtor
is on notice that the information in the pleading is material.
What about the “record,” including exhibits, of a public hearing?
In 1994, the board of directors of chapter 11 debtor Crystal Brands, Inc., rejected
an acquisition offer from Phillips Van Heusen (PVH). A large minority of Crystal
Brands’ secured banks supported PVH’s bid, but the agent bank held out for a higher bid.
“[I]n enacting § 107(b), Congress did not intend that sealed pleadings be the rule in bankruptcy cases.”
In re Barney’s, Inc., 201 B.R. 703, 707 (Bankr. S.D.N.Y. 1996).
29
30
In re Foundation for New Era Philanthropy, 1995 WL 478841 at *4 (Bankr. E.D. Pa. May 18, 1995).
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PVH refused to make a higher bid unless it received information on the licensing
revenues received by the debtor on its intellectual property – information that, literally,
would fit on one piece of paper. The agent bank had the information but refused to
release it to PVH unless PVH raised its bid. Two days later, the agent bank and
Unsecured Creditors Committee appeared in court to litigate adequate protection and
collateral value – and one of the exhibits introduced into evidence, as part of the public
record, was the piece of paper listing license revenues. PVH obtained the exhibit, raised
its bid, won the banks’ support, and (eventually) bought Crystal Brands.
Under Regulation FD, the numbers in the exhibit were clearly material non-public
information. If Crystal Brands knows that its information is available in the court record
to investment professionals, has it made a knowing disclosure of material non-public
information selectively available to those investment professionals who obtain access to
the record? Would Crystal Brands be obligated today to file those numbers in an 8-K
once they were a matter of public record?
I certainly hope so.
One of the dirty little secrets of chapter 11 practice (and I suspect other litigation
practice as well) is that the “the public record” is much less of a “record,” and less
“public”, than it appears.31
Let us start with the exhibit introduced in evidence in Crystal Brands. In the
Bankruptcy Court for the Southern District of New York, where Crystal Brands filed, the
court does not keep exhibits or documentary evidence in its own files. Under Local Rule
39.1 of the U.S. District Court for the Southern District of New York, the introducing
31
Certain judges ignore the record because they take no time to read it. How often have we seen a judge
rule from the bench – or on the same day of a hearing – after the submission of hundreds of pages of
deposition transcripts or other exhibits that the judge has taken no time to read?
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lawyer is obligated to retain the exhibits. There is nothing in the local rules requiring the
lawyer to make the exhibits available to parties in interest. Query: Is a lawyer who
retains an exhibit filed in court an “officer of the court,” required to make such exhibits
(as “documents . . . relating to the affairs of an estate”) available for inspection under 18
U.S.C. § 154(2)? How quickly must the lawyer make the exhibits available? Human
nature being what it is, lawyers tend to make exhibits available somewhat more quickly
to friends and clients than to enemies and strangers. How long must the lawyer retain the
exhibits for inspection?
For that matter, how long must bankruptcy courts (or any courts) retain exhibits
for inspection? There are numerous prominent cases on the public’s “common law right
of access” to “all court records, including exhibits.”32 But a “right of access” to exhibits
is not worth much if no one keeps the exhibits. Except for cases of historical interest,
where the clerks of the federal district courts have been directed to deposit documentation
with the Federal Records Center,33 the retention of exhibits is left to the local rules
adopted by the district courts. Where local rules do not require attorneys (rather than the
court clerk) to retain exhibits,34 they tend to require the clerk to return or destroy exhibits
10 to 90 days after the expiration of any time to appeal a final disposition of a proceeding
has expired.35
32
United States v. Mitchell, 386 F. Supp. 639, 641 (D.D.C. 1974). See, e.g., Nixon v. Warner
Communications, 435 U.S. 589 (1978).
33
41 C.F.R. § 101-11.1; 44 U.S.C. §2107; see Mitchell, 386 F. Supp. at 641.
34
In addition to the Southern District of New York, the Northern District of Illinois (in ILR 791.1) requires
counsel to retain exhibits.
35
See, e.g., N. D. Ca. U.S.D.C. Civ. L. R. 79-4 (2001), 20 days; Del. Civ. Prac. L. R. 79.1 (2001), 30 days;
U.S.D.C. N. D. Tx. L. R. 79.2 (2001), 60 days.
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Take next testimony in open court. Large corporate debtors often have a “chief
reorganization officer” who is their most frequent witness. The debtor’s chief financial
officer will often testify. The court room may well be packed with investment
professionals. When the debtor’s witnesses disclose material information in testimony, is
the debtor obligated to file such information in an 8-K “immediately” or “promptly” after
the testimony?
Again, I hope so. Another dirty little secret: Gaining access to court transcripts is
increasingly difficult. As tape recorders replace court reporters, it takes weeks,
sometimes months, to obtain a transcript of a court hearing.36 Thus the investment
professional at the court hearing has a dramatic (should one say “unerodable?”)
informational advantage over the investor who is absent. If the debtor has a transcript of
the hearing and an investment professional asks for a copy, does Regulation FD require
the debtor to file the transcript with an 8-K?
What about negotiations?
Most issuers prefer to enter chapter 11 with a fully negotiated plan of
reorganization – a plan that they know creditors will support. If an issuer with publicly
traded debt plans to do a “true” pre-packaged plan of reorganization – one in which
bondholders vote on the plan before the bankruptcy – the issuer will proceed through an
exchange offer that is either registered on Form S-4, or not registered pursuant to the
exempt transaction outlined in section 3a9. Alternatively, the issuer may pursue a “prenegotiated plan,” where it reaches a semi-binding agreement with certain large
36
The delay in getting transcripts also affects the judicial process. Even the most conscientious
judge may feel compelled to rule before a transcript is available for review. Accordingly, appellate judges
may be the first jurists who can review the trial transcript.
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bondholders on terms of a plan to be filed with the bankruptcy petition and voted on after
the bankruptcy court approves a disclosure statement.
If the issuer proceeds via a registered exchange offer, Regulation FD will not
apply. If the issuer proceeds in any other fashion, Regulation FD will apply – because
every negotiating creditor is likely to be an investment professional. Prior to Regulation
FD, it was not clear that creditors had to be restricted as the price of negotiating a plan.
There were many bondholders who refused to receive non-public information about their
issuer to avoid restriction, but nonetheless believed they could negotiate the treatment of
their bonds under a plan without becoming restricted. However, if every company
proposal must be disclosed under Regulation FD unless the recipients have signed
confidentiality agreements, debtors will require all of the negotiating creditors to sign
confidentiality agreements. No creditor will be able to negotiate a plan unless it has
agreed to become restricted.
The flip side of Regulation FD – its consequences for recipients of material nonpublic information – remains to be explored.
Regulation FD is not an anti-fraud regulation: § 243.102, titled “No effect on antifraud liability”, explicitly provides that “no failure to make a public disclosure required
solely by § 243.100 shall be deemed to be a violation of Rule 10b-5”. The proposing and
adopting releases are explicit: Regulation FD can be enforced by the SEC only, it
provides no private right of action and it does not change the standards for liability under
Rule 10b-5.
Well, we’ll see about that. What about the “professional investor” who calls a
company’s investor relations (“IR”) people with a question. He gets an answer. He
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trades. In the old days, he had no 10b-5 liability – he called the company, as any other
investor could have done, asked a question, as any other investor could have done, and
got the same answer that any other investor could have obtained. He was, in short,
exercising “superior diligence.”
Now suppose the company’s IR people call the professional investor back and tell
him he got information that he wasn’t supposed to get. Is he restricted – even though he
never wanted information that would restrict him?
Regulation FD in its final form applies only to disclosures by senior officers and
employees whose duties include communication with investors – and from the issuer’s
point of view, it has to be that way. A company with 10,000 employees cannot possibly
know what each employee says to any investment professional at any time:
[Regulation FD] does not cover every employee who may occasionally
communicate with an analyst or security holder. Thus if an analyst sought to
ferret out information about an issuer’s business by quizzing a store manager on
how business was going, the store manager’s response ordinarily would not
trigger any Regulation FD obligations. Similarly, an employee who routinely
dealt with customer or suppliers would not come within this definition merely
because one of these customers or suppliers also happened to be a security holder
of the issuer.37
That works for the issuer, but does it work for the investor? Suppose the issuer has
adopted work rules that prohibit employees from talking to investment professionals.
Under Regulation FD, the professional investor who asks a question of an employee
bound by such work rules, who receives information, and then trades on it has received
information that is, by definition, [a] non-public (it hasn’t been “disclosed” pursuant to
Regulation FD), [b] material (if he asked for it and traded after getting it, he certainly
37
Final Release, at n. 36.
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thought it was material), and [c] provided in violation of the employee’s duties to his
employer. Must the professional investor now “disclose or abstain” from trading?
III. Liquidity and NOLs.
A. The Value of Liquidity.
In 1999 - 2000, my firm represented the unsecured creditors’ committee for a
company that made sub-prime mortgage to low income homebuyers in order to finance
the homebuyer’s purchase of homebuilding services from that company itself. The
company failed when its secured lender refused to continue to extend credit. The case
was very contentious, but the committee ultimately proposed a plan of reorganization.
The plan was to divide the company into an operating entity dedicated to restarting the
failed business, and a litigation entity dedicated to bringing a lawsuit against the lender.
Accordingly, the lender vigorously attacked the plan (and even proposed its own plan of
liquidation) in an effort to prevent the reorganization.
The lender launched every conceivable attack against the plan, but one in
particular was of theoretical interest. One class of unsecured creditors received only the
common equity of the new operating and litigating entities. There was no market for the
new equity: It was illiquid. The lender’s expert testified at confirmation that the
illiquidity of the equity securities reduced their value by 30%, and accordingly creditors
could not receive under the plan more than they would in liquidation.
In essence, the lenders argued that no chapter 11 plan could ever be confirmed
unless the debtor’s going concern value exceeded the debtor’s liquidation value by
more than the loss in value caused by the illiquidity of the plan securities.
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Moreover, the lender’s allegation that the illiquidity discount should be 30%
has some scholarly backing. Finance economists have developed a considerable
literature on the appropriate discount for illiquid securities,38 and 30% is certainly
within the range of estimated discounts. For example, one study finds a 35-40%
difference in the values of registered stock and stock that can be traded only under Rule
144.39 And one recent survey of discounts reports mean and median discounts in the
value of illiquid securities ranging from 20-35%, before positing its own estimate of
10.4% to 17.6%.40
Take, for example, a plan that distributes new secured bonds to senior secured
banks, cash to trade and common stock to subordinated bondholders. Shareholders
receive nothing. The senior secured banks and the trade vote for the plan; the
subordinated note holders vote against the plan because they believe they will do better if
the debtor is liquidated. Because old shareholders receive nothing, the plan can be
“crammed down” on the subordinated bonds under § 1129(b)(2)(B)(ii). However, the
subordinated bonds should not be forced to take common stock under § 1129(a)(7) unless
the value of the stock after giving effect to any liquidity discount is greater than the cash
expected from liquidation.
38
The following survey of financial economic literature was made possible by a timely and invaluable
assistance of Professor Stuart Gilson of the Harvard Business School. The literature is extensive, and the
author lacked both the time and the academic training to do more than give a brief and incomplete survey;
any omissions, errors or biases are mine.
39
Langstaff, How Much Can Marketability Affect Security Values?, 50 J. Fin. 1767, 1995 WL 12353804
(Dec. 1, 1995). Langstaff’s article derives a maximum discount that should be applicable to illiquid equity
securities based on option pricing theory. Langstaff then compares his theoretical maximum discount it to
empirical studies of actual trading discounts, and finds the two are almost the same.
40
Bajaj, Denis, Ferris & Sarin, Firm Value and Marketability (Feb. 25, 2001), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=262198.
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Take another example: A debtor plans to distribute all of its new common stock to
unsecured creditors, one of whom holds 25% of the debt. All of the other creditors vote
for the plan; the 25% creditor votes against. The stock issued to the 25% creditor will be
illiquid because, under the securities laws, the creditor is receiving enough stock to be an
underwriter and cannot trade its securities without registration. The debtor refuses to
give the unsecured creditor registration rights. Why should the 25% creditor be stuck
with illiquid stock against its will? Why isn’t this “discrimination within a class”
prohibited by § 1123(a)(4)? The 25% creditor, by receiving illiquid securities, receives
distributions that are worth less per dollar of claim than the small creditors receiving
liquid securities.
The fact is that liquidity has a value – or, more accurately, that illiquidity imposes
a discount.
This point is driven home by In re Piece Goods Shops Company, L.P.41 In Piece
Goods, a creditor argued that its stock was illiquid and therefore not worth more than it
would receive upon liquidation. At confirmation, the plan proponents had rebutted the
arguments by introducing evidence that the plan securities would be liquid – because
there was already a liquid market in claims during the chapter 11 case:
According to the [Debtors’ expert] Mr. Holmes, there are three general levels of
stock value: (1) control value, (2) freely traded minority value, and (3) closely
held value. The stock prices for Hancock and Fabricenter, which he used in
valuing the New Common Stock, represent freely traded minority values. By
contrast, the New Common Stock will not be publicly traded when distributed on
the Effective Date. This lack of marketability suggests some discount in value
from the freely traded minority values of Hancock and Fabricenter. However,
because claims have traded in these cases and based upon his experience in
other chapter 11 cases, Mr. Holmes believes that a secondary market will be
created for trading in the New Common Stock. For that reason, he views the
lack of marketability discount as being smaller than if the New Common Stock
were closely held with little or no trading. In addition, Mr. Holmes considers the
41
188 B.R. 778 (Bankr. M.D.N.C. 1995).
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lack of marketability discount to be offset by the possibility that the Debtors are
sold after the effective date and, through the “drag along” provision, the control
premium is realized by all shareholders, including those with minority interests.
Based on these and other considerations, Mr. Holmes concluded that the value to
holders of $31.50 per share is not reduced by the fact that the New Common
Stock will not be publicly traded on the effective date of the Plan. Mr. Matt
reached the same conclusions.42
The Piece Goods court gave “great weight to the expert opinions of Messrs.
Holmes and Matt,” and adopted their value of $31.50 per share.43
In other words, the existence of a free and active market in claims during a
chapter 11 case is not the sideshow or distraction that some think it is. The market in
claims during a chapter 11 case adds value to the securities distributed under the chapter
11 plan. To the extent the market is frozen by court order, the freeze not only diminishes
the value of the claims in the creditors’ hands, it also diminishes the value of the
securities to be issued under any chapter 11 plan. That in turn increases the risk that the
securities’ value will fall short of the cash distributable to creditors upon liquidation.
This brings us to the cases in which debtors have sought to enjoin trading in
claims in order to preserve a tax attribute: net operating loss carry-forwards, or “NOLs”.
B. The Care and Feeding of NOLs.
A corporation that makes money one year and suffers losses the next can “carry
back” the NOLs from year 2 and apply them to the income of year 1, thereby obtaining a
refund of the taxes payable on year 1 income. Indeed, operating losses can be “carried
back” two years.44 However, many corporations in chapter 11 have gone more than two
years without a profit. These corporations can instead take their net operating losses and
42
Id. at 792 (emphasis added).
43
Id. at 793.
44
26 U.S.C. § 172(b)(1)(a)(i).
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“carry them forward” to shelter income in the future. Each year’s NOLs can be “carried
forward” for twenty years – that is, the loss year 2 can be applied to shelter income in any
of years 3 through 22.
Congress, however, does not approve of “trading in losses.” Accordingly, if the
corporation with the NOLs undergoes an “Ownership Change” in any three-year period,
its ability to use its NOLs will be limited to a specified percentage of its net worth at the
time of the change.45 The percentage is published by the IRS each month and is, in
layman’s terms, the average interest rate paid on long term tax exempt securities (often
referred to as the “applicable federal rate”, or “AFR.”46
The Internal Revenue Code (“IRC”) determines whether an Ownership Change
has occurred as follows: On the date of any owner shift, equity structure shift, and on
certain other dates (each, a “Testing Date”), the loss corporation must determine who
holds 5% or more of its stock. The “public,” defined to mean the mass of holders who
each hold less than 5%, is deemed to be one shareholder. Accordingly, if on January 1,
2004 (a Testing Date), A holds 15%, B holds 10%, C holds 6% and the public holds the
balance (69%), there are four “5%” shareholders: A, B, C and the public.
The loss corporation must then determine the holdings of A, B, C and the public
on each day during the three years prior to the Testing Date – that is, during the period
January 1, 2002 through December 31, 2004 (the “Testing Period”). If the holdings of
any or all of the 5% holders have increased from their low point during the Testing
Period to the holdings on the Testing Date, the loss corporation must take each holder’s
45
26 U.S.C.§ 382(b).
46
Technically, the AFR is the highest of the adjusted federal long-term rates in effect for any calendar
month in the 3-calendar month period ending with the calendar month of the Ownership Change. The
adjusted federal long-term rate means the average yield on federal long-term obligations with certain
adjustments. 26 U.S.C. § 382(f).
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increase and add it to all the increases of the other holders. If the increases add up to
more than 50%, an Ownership Change has occurred.
In the example above, assume that A held its 15% from the beginning but B and C
have acquired their 10% and 6% since January 1, 2002. Accordingly, the public held
85% on January 1, 2002 and now holds 69% (no increase); B and C increased from 0% to
10% and 6%, respectively, but those increases aggregate only 16% -- so no Ownership
Change has occurred.
Now assume, by contrast, that on January 1, 2002, A held 25%, B held 26% and
the public held the balance, or 49%. Assume A and B sold all their shares to C. C went
from 0% to 51%, and thus an ownership change has occurred. Alternatively, assume A
and B sold their shares into the market. Now the public has gone from 49% to 100% -and an Ownership Change has occurred (!).
As noted in Part I, large corporate reorganizations almost always distribute
common stock to creditors. This distribution would constitute an Ownership Change, and
would normally limit use of the debtor’s NOLs to the product of the AFR multiplied by
the market value of the debtor’s stock. However, IRC § 382(l)(5) and regulations
adopted thereunder provide that a chapter 11 Ownership Change will not limit the
debtor’s use of its NOLs if the chapter 11 plan distributes at least 50% of the stock of the
reorganized debtors to certain creditors:
1. Creditors who have held their claims at least 18 months before the
commencement of the chapter 11 case;
2. Creditors who have held claims that arose after the 18 month cutoff if the
creditors have always held such claims and the claims arose in the ordinary
course of the debtor’s business; and
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3. Generally, creditors who receive less than 5% of the stock issued under the
plan and who have not, to the debtor’s knowledge, participated in the
negotiation of the plan.47
Creditors in these categories are colloquially called “old and cold” creditors.48
Where claims are actively traded, an increasing percentage may be held by creditors who
are not “old and cold.” If the claims are accumulated by a few creditors, more and more
creditors will hold enough claims to receive 5% or more of the stock distributed under the
plan. I refer to those creditors as “5% creditors.” Where the total percentage of the 5%
creditors exceeds 50%, IRC § 382(l)(5) will no longer be available and the reorganized
debtor’s use of its NOLs will be limited to the AFR multiplied by the market value of the
debtor’s stock.
The market value of the debtor’s stock is set immediately before the Ownership
Change,49 which in the case of insolvent corporations should be close to zero.
However, a debtor who cannot meet the requirements of IRC § 382(l)(5) may use
IRC § 382(l)(6), which sets the market value of the common stock immediately after the
Ownership Change (thus reflecting the increased value resulting from any discharge of
creditors’ claims).
Thus stood the law until December 31, 1994. Several debtors with large NOLs
grew concerned that claims trading would limit their NOLs, and they prevailed upon
courts to issue orders enjoining, or limiting, claims trading. Each debtor argued that its
47
This rule does not apply to an entity through which a 5% shareholder holds an indirect ownership interest
in the debtor corporation. In addition, the rule does not apply to indebtedness beneficially owned by a
person whose participation in formulating a plan of reorganization makes evident to the debtor corporation
that the person has not owned the indebtedness for the requisite period. Treasury Regulation § 1.3829(d)(3).
Technically, creditors in categories 1 and 2 are “old and cold” under IRC § 382(l)(5) and less-than-5%
creditors in category 3 are deemed by the IRS to be “old and cold” under 26 C.F.R. § 1.382-9(d)(3).
48
49
26 U.S.C. §§ 382(b), 382(e).
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NOLs were property of its estate and that claims trading, by creating more 5% creditors,
threatened to destroy the debtor’s unrestricted access to NOLs under IRC § 382(l)(5).50
There was authority to support an injunction to protect NOLs: In re Prudential
Lines Inc.51 Prudential Lines involved a subsidiary in chapter 11 and a non-bankrupt and
solvent parent. The Committee of Unsecured Creditors filed and confirmed a plan that
wiped out the parent’s old equity and distributed new stock to creditors. The parent then
took a “worthless stock deduction,” because its stock in the subsidiary was obviously
worthless. However, the “worthless stock deduction” caused the elimination of the
subsidiary’s NOLs.52 The Unsecured Creditors’ Committee wanted the NOLs preserved
for the benefit of the debtor-subsidiary. The Committee therefore argued that the parent,
by taking the worthless stock deduction and eliminating the subsidiary’s NOLs, had taken
“property of the estate” and violated the automatic stay under Code § 362(a)(6). The
U.S. Court of Appeals for the Second Circuit agreed, holding that the NOLs were
property of the subsidiary’s estate and protected by the automatic stay.
Prudential Lines enjoined the debtor’s parent from destroying the debtor’s NOLs,
so other debtors have cited Prudential Lines to support an injunction against claims
trading that threatens the debtor’s unrestricted access to NOLs under IRC § 382(l)(5).53
The application of Prudential Lines to trading injunctions is taken for granted, but the
In re Phar-Mor, Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993); In re Ames Dep’t Stores, Inc., 127 B.R.
744 (Bankr. S.D.N.Y. 1991); In re Pan Am Corp., 1991 Bankr. LEXIS 1061 (Bankr. S.D.N.Y. 1991); In re
McLean Industries, Inc., 103 B.R. 424 (Bankr. S.D.N.Y. 1989).
50
51
In re Prudential Lines, Inc., 928 F.2d 565 (2d Cir.).
52
26 U.S.C. § 382 (g)(4)(D).
See In re Casual Male Corp., (Bank. S.D.N.Y. May 18, 2001); “Motion of Debtors for Order Pursuant to
11 U.S.C. §§ 105; 362 and Bankruptcy Rule 3001 Establishing Notification and Hearing Procedures for
Trading in Claims Against Debtors” See In re Service Merchandise Co., Inc., (M.D. Tenn. March 15,
2000); In re First Merchants Acceptance Corp., 1998 Bankr. LEXIS 1816 (Bankr. D. Del. 1998) and cases
cited in n. 49, supra.
53
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cases that cite it granted injunctions either without opposition, or to freeze trading on the
verge of consummation of chapter 11 plans. There are, in fact, grave procedural and
substantive problems in using Prudential Lines to enjoin claims trading.
With respect to procedure, how can the parties affected by the injunction against
claims trading get notice or be served? Claims trade in a vast market, including the
securities markets. How are participants in these markets supposed to know that they are
violating the injunction or the automatic stay? It is possible to give notice to all the
possible sellers because they are existing creditors, but that will require a mass-mailing.
What if the mailing comes too late? Do Prudential Lines and § 362(a)(6) make void all
the trades that created the Ownership Change, and if so how is that to be accomplished?
Next, substance: In Prudential Lines, the parent knowingly took action to obtain
dominion over the NOLs. In claims trading, parties are buying and selling claims on a
market, and the effect on the NOLs is incidental. The situation is no different from one
faced in real estate cases, where the individual partners are debtors and mortgaged
property is owned by a non-debtor partnership. Foreclosure on the property will often
create horrific tax consequences for the partners, but no court has ever held that tax
consequences of foreclosing on a partnership mortgage constitutes a violation of the stay
in the bankruptcy of a partner.54 Neither situation is so different from a neighbor’s
construction which blocks the debtor’s view. The view may be a valuable asset of the
estate, but the neighbor’s building does not violate the automatic stay.
Note also that the Treasury Regulations deem less-than-5% creditors to be “oldand-cold” only if they play no role in negotiating the plan. Suppose several less-than-5%
54
See In re Cardinal Indus., Inc., 105 B.R. 834, 849 (Bankr. S.D. Ohio 1989) (although action against
non-debtor partnership diminished value of debtor’s partnership interest, it did not violate automatic stay).
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shareholders make IRC § 382(l)(5) inapplicable by hiring counsel to negotiate changes to
the plan. Have they violated the stay?
Finally, note that preserving unrestricted use of NOLs under IRC § 382(l)(5)
requires more than an injunction against claims trading during the chapter 11 case. It also
requires freezing stock trading (by charter provisions or court order) after the chapter 11
case is over.
Suppose an “old-and-cold” creditor – such as a large original bank or bondholder
– receives 51% of the reorganized debtor’s stock. If that creditor sold all of its stock, the
sale would create an Ownership Change. The Ownership Change would limit the use of
the NOLs to the product of the AFR times the market value of the common stock55 –
eliminating the value of IRC § 382(l)(5) and the freeze on claims trading during the case.
Accordingly, that creditor cannot be allowed to sell its stock unless the reorganized
debtor can determine that the sale will not create an Ownership Change.
Now suppose each of 10 creditors receives 5% or more of the reorganized
debtor’s stock. None of the 10 creditors can be allowed to sell its stock unless the
reorganized debtor can determine that the sale will not, together with other sales, create
an Ownership Change.
Now suppose that a third party wants to make a tender offer for more than 50% of
the reorganized debtor’s common stock. The reorganized debtor’s charter must block
such tender offer – must prohibit shareholders from accepting the tender without the
consent of the board of directors – because the tender offer will create an Ownership
Change.
55
26 U.S.C. §§ 382(a); 382(b)(1).
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All of these consent-before-trading limits are required to preserve the benefit of
IRC § 382(l)(5)’s unrestricted access to NOLs. To ensure the survival of that benefit, the
consent-before-trading requirements must remain in place for the life of the NOLs – up to
20 years. Otherwise, IRC § 382(l)(5)’s unrestricted access to NOLs could be vitiated by
an Ownership Change the day after the chapter 11 plan is consummated.
In sum, preserving unrestricted use of NOLs under § 382(l)(5) is neither easy nor
cheap. Before a court jumps to enjoin trading, perhaps it should consider whether the §
382(l)(5) exemption is worth preserving.
C. The Effect of COD on NOLs – and other Tax Attributes.
Outside of bankruptcy, a taxpayer earns taxable income when a creditor releases
or cancels its claim for property (including stock of the taxpayer) having a value less than
the amount of the claim – colloquially referred to as “cancellation of debt” or “COD”
income.56 Where the taxpayer issues stock for debt, the value of the stock is determined
by its trading price immediately after issuance. As noted in the Introduction, the essence
of large corporate reorganizations is the conversion of claims against the debtor into
common stock of the reorganized debtor. Except in the rare instance where the debtor is
solvent (and the even rarer instance where the trading price of the stock reflects that
solvency), the debtor always issues stock with a trading value less than the allowed
amount of the claim discharged – which produces COD. The Internal Revenue Code
provides that, in chapter 11, the taxpayer/debtor does not have to pay tax on its COD
income, but may instead use the COD income to reduce its tax attributes, presumptively
in this order:
56
26 U.S.C. §§ 61(a)(12), 108(a).
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1. NOLs,
2. tax credits,
3. capital loss carryovers,
4. tax basis in depreciable property,
5. tax basis in other property.57
Prior to 1995, the Internal Revenue Code contained an exception for chapter 11
plans distributing stock to “old and cold” creditors under IRC § 382(l)(5): COD would
reduce its tax attributes under a § 385(l)(5) plan by only 50% of the amount of the COD,
plus three years of interest on the amount of the debt discharged by stock. Accordingly,
prior to 1995, a substantial portion of tax attributes (including NOLs) could survive COD
in chapter 11.
Effective 1995, the law changed: Even under IRC § 382(l)(5) plans, tax attributes
would be reduced by 100% of COD – and in addition, the taxpayer/debtor would still lose
an additional amount of NOLs equal to three years’ of interest on the amount of the debt
discharged by stock. Unrestricted access to NOLs under § 382(l)(5) is less important if
the NOLs are eliminated or substantially reduced by COD.
There remains, however, a way to preserve NOLs from COD. Although, as noted
above, the Internal Revenue Code presumes that COD reduces NOLs and credits before
other tax attributes, the debtor can elect to have COD reduce its tax basis in depreciable
property first, so that NOLs are preserved.58
At first blush, it looks like the debtor should always elect to reduce depreciable
basis first. Both NOLs and depreciable basis generate tax shelter, but under § 382(l)(5) a
57
26 U.S.C. § 108(b).
58
26 U.S.C. § 108(b)(5).
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debtor can use all of its NOLs to shelter all of its income, while depreciation is limited to
a percentage of depreciable basis. In other words, $100 million in NOLs can shelter $100
million in income in one year. By contrast, $100 million in depreciable basis of property
with a 10-year useful life can only shelter $10 million per year.59
Note that the opposite may be true if § 382(l)(5) is not available. Under IRC
§ 382(l)(6), NOLs can shelter income only to the extent of the AFR multiplied by the
post-Ownership Change market value of the stock. If the AFR is 5% and the market
value of the reorganized debtor’s common stock is $150 million, NOLs under § 382(l)(6)
generate only $7.5 million in tax shelter, as opposed to the $10 million per year from
depreciation.
D. A Cost/Benefit Analysis of § 382(l)(5).
Now we have all the tools we need to determine whether unrestricted access to
NOLs under § 382(l)(5) is an asset worth preserving.
First, we need to quantify the actual benefit of unfettered use of NOLs under IRC
§ 382(l)(5), as opposed to allowing an Ownership Change and proceeding under IRC
§ 382(l)(6).
A debtor benefits from IRC § 382(l)(5) only to the extent it pays less tax than
under IRC § 382(l)(6). Assuming NOLs survive COD, under § 382(l)(5) all of the
debtor’s income is sheltered from tax. At the 35% tax rate for corporations earning
taxable income over $10 million per year,60 the tax savings are:
35% x Earnings (“E”)
59
The example assumes, for purposes of illustration, straight-line depreciation. Accelerated depreciation
would increase the amount of the deduction in the early years and would decrease the amount of the
deduction in the later years.
60
26 U.S.C. § 11(d)(1)(D).
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Under § 382(l)(6), tax savings from NOLs are limited to:
35% x (AFR x market value of stock)
So the tax saved under IRC § 382(l)(5) each year is the difference between the
two formulas:
35% x E – 35% x (AFR x market value of stock)
The cumulative value of the tax saved under IRC § 382(l)(5) is equal to the discounted
present value of that difference for as long as the NOLs are available: 20 years, unless the
earnings to be sheltered from tax use up the NOLs on a faster schedule.61
The discounted present value of the tax savings depends on the discount rate. For
ease of analysis, let us assume that the reorganized debtor’s income is constant, and
therefore its tax savings are the same, year after year. Let us further assume that the
reorganized debtor has an infinite amount of NOLs, which will accordingly shelter all of
its income for 20 years. The present value of constant annual tax savings when
discounted at a discount rate of “r” over an infinite number of years (and 20 years, for
these purposes, is comparable to an “infinite number”) is mathematically equivalent to
one year’s tax savings multiplied by a capitalization rate “k” equal to 1/r.
In other words, if the appropriate discount rate is 20%, the capitalization rate k is
5x. I like to determine the value of tax savings by multiplying one year’s savings by k
rather than by discounting using r because
annual tax savings” is a lot simpler than “∑n: 1 to 20 1/(1+r)n x
annual tax savings”; and
 “k x
61
For example, a reorganized debtor earning $50 million per year will use up $200 million in NOLs over
four years.
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 “k” is easy to figure out: the capitalization rate for any corporation is the
price-to-earnings ratio (“pe”) of the reorganized debtor’s common stock. In
other words, each $1 of tax savings should be worth $1 x pe in value. The
reorganized debtor’s pe can be predicted by looking at the pe ratios of
comparable corporations.
Accordingly, the value of tax savings is equal to “pe x annual tax savings.”
Having predicted the reorganized debtor’s pe ratio from the ratios of other
companies, we can also predict the market value of the debtor’s stock by multiplying its
reported Earnings by the pe ratio. So the equation that determines the value of IRC
§ 382(l)(5) can be written thus:
pe x [35% x E - 35% x AFR (E x pe)]
which expanded is
pe x 35% x E – pe x 35% x AFR x E x pe
That is the benefit of IRC § 382(l)(5) vs. IRC § 382(l)(6). However, the benefit
comes at a cost – the cost of restrictions on trading claims against the debtor in chapter 11
and the cost of restricting trading in the debtor’s stock after chapter 11. The cost of those
restrictions – the “illiquidty discount, or “il” -- can be expressed as a fraction of the value
of the reorganized debtor’s stock. As noted above, the value of the debtor’s stock should
be the product of the projected pe ratio and projected Earnings. Accordingly, the cost of
the IRC § 382(l)(5) exemption can be expressed as:
E x pe x il
The total cost/benefit formula can therefore be set forth as follows:
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pe x 35% x E
(being the value of taxes saved under §
382(l)(5))
minus
pe x 35% x AFR x E x pe
(being the value of taxes that could be
saved under § 382(l)(6) by using NOLs at
an annual rate of 5%-of-stock-market-value
per year)
equals the net benefit of § 382(l)(5), and must exceed
E x pe x il
(being the cost, in illiquidity, paid to
preserve § 382(l)(5)’s access to NOLs).
Or,
pe x 35% x E – (pe x 35% x AFR x E x pe) > E x pe x il
Dividing each side of the equation by common terms E and pe, we can restate the
equation as follows:
35% - (35% x AFR x pe)
> il
The foregoing algebra proves a couple of interesting points.
First, so long as NOLs are large enough to survive COD in size sufficient to
shelter 20 years of projected Earnings, increases in NOLs and increases in projected
Earnings will not necessarily affect the relative value of IRC § 382(l)(5)’s unrestricted
access to NOLs and the cost of the liquidity freeze that preserves such access. The more
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Earnings are projected, the more the projected value of the tax shelter, but also the
greater the cost of the liquidity freeze. If NOLs are limited, however, the converse may
not be true. If projected Earnings fall, the amount of COD goes up and may deplete or
eliminate the NOLs.
Second, the relative value of the tax shelter decreases as the pe multiple goes up.
Let’s do some numbers.
As of October 2004, the AFR is 4.64%. Let us assume that the pe is 10 – that is,
the reorganized debtor is trading at 10 times earnings.
The equation then looks like this:
35% - (35% x 4.64% x 10) > il
or
18.76% > il
In other words, at a price/earnings multiple of 10 the illiquidity discount il must
be less than 18.76% for the benefit of IRC § 382(l)(5)’s unrestricted access to NOLs to
exceed the cost of the necessary trading restrictions. Applying the formula to other pe‘s
yields the following table:
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If the price/earnings ratio is:
Then freezing trading to preserve IRC §
382(l)(5)’s access to NOLs makes no sense
unless the liquidity discount is less than:
4
28%
5
26.25%
6
24.5%
7
22.75%
8
21%
9
19.25%
10
17.5%
11
15.75%
12
14%
13
12.25%
14
10.5%
15
8.75%
16
7%
17
5.25%
18
3.5%
19
1.75%
20
0%
At the beginning of this Part III, I cited several studies estimating the size of
liquidity discounts. The most popular estimate of the appropriate discount for illiquid
stock was 30%. Thus, based on simple arithmetic – pure mathematics, without reference
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to the particulars of the debtor – it is not clear that the value of unrestricted access to
NOLs under § 382(l)(5) is worth the cost of the trading restrictions necessary to preserve
that access.
I close with the following observations.
First, the formula values tax savings from NOLs using one capitalization rate k.
The formula assumes k is approximately equal to the pe ratio because pe is the
capitalization rate used to value the debtor’s Earnings over an infinite period of time and
k is used to value a stream of tax savings (incremental Earnings) over 20 years, 20 being
not materially different (for these purposes) from infinity. However, under IRC §
382(l)(5), NOLs may not last 20 years. Indeed, where the debtor applies COD to reduce
depreciable basis in order to save NOLs, the debtor’s post-chapter 11 taxable income
goes up (because it has no depreciation deductions) and its NOLs will be used up that
much faster. Thus the value of tax savings under IRC § 382(l)(5) is less because the
number of years the debtor realizes those savings goes down.
Second, all of the formulas use 35% as the federal income tax rate to determine
the value of taxes saved. That percentage is almost certainly too high. The tax rate on
net earnings of less than $10 million per year is less than 35%,62 and if the reorganized
debtor uses NOLs to eliminate regular corporate tax on earnings, it still must pay
alternative minimum tax – so it never saves 35% of projected Earnings. It always saves
less.
62
26 U.S.C. § 11(b).
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Third, all of the foregoing calculations value the NOLs assuming a constant,
steady level of income. It is possible that the reorganized debtor can accelerate the
benefit of IRC § 382(l)(5)’s unrestricted access to NOLs by acquiring a business with
taxable income. This possibility is remote. The reorganizing debtor would have to use
cash or a limited percentage of its stock to make an acquisition. Few companies
emerging from chapter 11 have either sufficient cash, or sufficiently attractive stock, to
implement such a strategy.
The foregoing provides some mathematical and intellectual rigor analyzing the
value of IRC § 382(l)(5)’s unrestricted access to post-reorganization NOLs. Such rigor is
needed. Debtors’ management does not fulfill its fiduciary duty to creditors by adopting
trading restrictions that cost more in liquidity discounts than the NOLs value that the
restrictions preserve, and bankruptcy courts should not blindly accept preservation of
access to NOLs as a reason to freeze trading. Even if trading in claims can be enjoined
to save NOLs, that does not mean that trading in claims should be enjoined to save
NOLs.
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