PEPPERDINE UNIVERSITY SCHOOL OF LAW
FINAL EXAM:
Business Reorganization
in Bankruptcy-Essay Portion
TOTAL NO. OF QUESTIONS:
SPRING 2003
2
TOTAL NO. OF PAGES:
6
(including present value tables)
PROFESSOR
Scarberry
TIME:
Two (2) Hours
____________________________________________________________________________
INSTRUCTIONS
1.
This portion of the exam consists of two essay questions. The first essay question is
shorter than the second and will not count quite as heavily. I suggest you spend fifty
minutes on Essay 1 and 70 minutes on Essay 2; the questions will be weighted in that
proportion in the grading. These two essays together will count as two-thirds of your final
examination grade. The multiple choice section will count one-third.
2.
You are permitted to use the casebook, the statutory supplement (annotated as you wish),
your notes, any other written or printed material that you wish, and a calculator on this
portion of the examination. Note, however, that you will not be able to access any
material on your laptop computer during this exam, whether or not you are using
ExamSoft.
3.
Please use blue or black pen only (unless you are typing or using ExamSoft), and start
each question in a separate bluebook.
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Essay 1 — Fifty Minutes
Durin Limited Partnership (DLP) owned the Lonely Mountain Office Tower, a seven
story office building. Minas Tirith Mortgage Co. (MTM) financed DLP’s purchase of the Tower
in 1995 and had promptly recorded its mortgage on the Tower. For the past several years, Elvish
Enterprises (EE) had rented the three top floors, but its lease expired in October, 2002. Elvish
Enterprises chose not to renew the lease and instead relocated to the beautiful new Lothlorien
Woods Office Center. DLP’s manager (general partner Thorin) had been sure that EE would stay
and thus did nothing to arrange for a new tenant; even once EE notified DLP that EE would be
leaving, Thorin did not start seeking a new tenant very vigorously, because Thorin thought he
could change EE’s mind. That was a very poor business strategy. Once EE actually left, Thorin
realized his mistake and diligently sought a new tenant; but the shortfall in rent caused great
difficulties. DLP made the November 1 and December 1, 2002 mortgage payments to MTM, but
then asked MTM if it would be possible to skip a few months’ payments while a new tenant
was found. MTM said “no,” and threatened to foreclose if any payment was missed; MTM also
was worried that a check from DLP might bounce, and thus MTM pressured DLP to make the
January 1, 2003 mortgage payment by cashier’s check. DLP had never paid by cashier’s check
before, but did so on January 1, in order to placate MTM. However, DLP was unable to make the
February 1 or March 1, 2003 payments, and MTM began foreclosure proceedings. In response,
DLP filed a chapter 11 petition on March 20.
As of March 20, the Tower was worth about $3.2 million (three million two hundred
thousand dollars), and the amount owed on the MTM mortgage was $3 million. MTM
immediately sought relief from the automatic stay in order to foreclose. MTM also sought an
order that a trustee be appointed, on the ground that Thorin had mismanaged the Tower. The
evidence showed that wear and tear on the Tower would likely cause its value to drop by $20,000
per month. Monthly interest on the mortgage at the contract rate was $15,000 per month. In
opposition to the motion for relief from stay, DLP filed written guarantees from Oin and Gloin
(two wealthy limited partners in DLP) that the value of the Tower would not drop below $3
million. They promised to pay to MTM any shortfall should the Tower bring less than $3 million
at any later sale or should the court value the Tower at less than $3 million in connection with
confirmation of a plan. They backed up their guarantee with a first lien on their multimillion
dollar real property, the Moria Mine.
The court denied both of MTM’s motions. DLP then sought to recover the January 1,
2003 mortgage payment from MTM as an alleged preference; the court ruled against DLP. On
June 15, DLP filed a proposed plan that provided for full payment of MTM’s secured claim by
monthly payments over 15 years with 4% interest. Four percent was the market rate for a first
mortgage in the amount of 80% of the value of an office building like the Tower; of course
MTM’s mortgage was for much more than 80% of the Tower’s value. On June 25, MTM once
again moved for relief from the automatic stay. Up to this point DLP had made no postpetition
payments to MTM.
[CONTINUED ON NEXT PAGE]
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Please discuss the following questions:
(1)
(2)
(3)
(4)
Did the court rule correctly in denying MTM’s initial motion for relief from the automatic
stay?
Did the court rule correctly in refusing to order appointment of a trustee?
Did the court rule correctly in refusing to avoid the January 1 payment as a preference?
Should the court grant MTM’s June 25 motion for relief from the automatic stay?
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Essay 2 — Seventy Minutes
DoodleCorp (DC), a corporation all of whose stock was owned by Betty Yankee,
operated a wholesale art supply business. DC would buy several hundred thousand dollars of art
supplies each month from manufacturers on 60 to 90 days’ unsecured credit. DC would typically
ship $30,000 to $40,000 of supplies per month to each of its ten major customers, who would
then be obligated to pay DC for the supplies within 60 days of shipment. All of this was in line
with typical practices of other wholesale art suppliers. Finagle Finance Co. (FFC) had a properly
perfected security interest in DC’s inventory of art supplies and in DC’s accounts receivable
(including, according to their agreement, “after-acquired inventory and after-arising accounts”).
DC got into financial trouble, but managed to stay out of bankruptcy for a while due to a
$400,000 loan from Joanna Yankee, Betty’s sister. To convince creditors to give DC a chance,
Joanna agreed with DC that Joanna’s loan would not be paid back until and unless all other
creditors had been paid in full. DC continued to lose money, and on November 1, 2001, DC filed
a chapter 11 petition.
During November, 2001, DC continued to sell art supplies to its major customers on 60
days’ credit, although orders were only half to two-thirds as large as they had been in the past.
(Some of the customers were worried that DC would go out of business; thus they started finding
other suppliers.) The only supplies DC bought during November were $50,000 worth of supplies
from one manufacturer that was willing to sell to DC on 60 days’ unsecured credit, even though
DC was in chapter 11. DC also had several pieces of used equipment (a forklift, several power
saws, etc.) that were not subject to any liens and that DC did not think it would need. DC had
never sold any equipment before, but, in order to raise cash, DC sold the used equipment on
November 20, 2001, for its fair market value, $15,000. DC did not ask court approval, nor did it
notify FFC or anyone else, before buying and selling the art supplies, and selling the used
equipment, during November, 2001.
In December, 2001, FFC claimed that DC’s actions during November were in violation of
the Bankruptcy Code. FFC also claimed that its security interest extended to the $50,000 in art
supplies DC bought during November, and thus that FFC had a lien on those supplies. The court
decided these and other matters, and gradually DC turned its business around.
Assume it is now late December 2002. DC finally is ready to seek confirmation of a plan
of reorganization. The court has determined that FFC is owed $2 million, and that its collateral is
worth $1.5 million. The only other prepetition claims are $8 million in unsecured trade claims
and Joanna’s $400,000 unsecured claim. Among other terms, the plan provides that FFC’s
secured claim will be in its own class, Class 1; that all general unsecured claims (other than
Joanna’s) will be in Class 2; that Joanna’s unsecured claim will be in Class 3; and that Betty’s
stockholder’s interest will be in Class 4. The claim in Class 1 will be paid by five yearly
payments of $366,000 each, which is sufficient to pay off a $1.5 million debt at a fair market
interest rate of 7%. Class 2 claims will receive $5 cash, a $15 promissory note at a fair market
rate of interest, and one share of stock in the reorganized DC, for each $100 of claim. For her
Class 3 claim, Joanna will receive merely 4,000 shares of stock in the reorganized DC. Betty will
receive nothing on account of her Class 4 stock, and her stock will be canceled. The reorganized
DC will have no debts other than the debts owed to FFC and to Class 2 claim holders as provided
in the plan. Assume FFC makes the section 1111(b)(2) election.
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DC’s expert testifies that the present value of the anticipated free cash flows from DC’s
business for the five year projection period (Jan. 1, 2003 to Dec. 31, 2007) is $2 million.
Projected earnings before interest for the fifth year are $800,000; to get to that figure, projected
expenses were of course subtracted from projected revenues, and the expenses included a
projected $200,000 in depreciation and amortization. The expert testifies that DC’s cost of
capital (or discount rate, or the rate of return an investor would demand who would buy DC’s
assets free of debts) is about 16%. EBITDA multiples for four comparable companies are 5, 6, 6,
and 7. There are no unneeded, surplus assets.
Please discuss the following questions:
(1)
(2)
(3)
(4)
(5)
(6)
Which, if any, of DC’s postpetition actions during November, 2001, violated DC’s
obligations under the Bankruptcy Code?
Was FFC correct in its claim that it had a lien on the art supplies DC bought during
November, 2001?
Based on the testimony of DC’s expert, what is the reorganization value of DC? Please
use the discounted cash flow method, and use both methods we considered for calculating
the residual value as part of the discounted cash flow method.
Assume the reorganization value of DC is $5 million, and that the court confirms DC’s
plan. What will be the value of a share of stock in the reorganized DC?
Does the plan treat FFC’s secured claim class, Class 1, fairly and equitably?
Does the plan treat Class 2 fairly and equitably? Will that matter if Class 2 accepts the
plan?
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