Amicus Curiae Brief — US Bancorp Mortgage Co. v. Bonner Mall Partnership

Supreme Coud, @.S

FILED

i |

No. 93-714 FEB 22 1994

iin CLERK

In The

Supreme Court of the United States

October Term, 1993

S

U.S. BANCORP MORTGAGE COMPANY,

Petitioner,

Vv.

BONNER MALL PARTNERSHIP,

Respondent.

°

On Writ Of Certiorari To The

United States Court Of Appeals

For The Ninth Circuit

+

AMICUS CURIAE BRIEF OF CHARLES W. ADAMS

IN SUPPORT OF NEITHER PARTY

+

CHarLes W. ADAms

Professor of Law

The University of Tulsa College

of Law

3120 East Fourth Place

Tulsa, OK 74104

(918) 631-2437

Amicus Curiae

—_—_—— —- — TS

—— — $$. $$$ —-—

COCKLE LAW BRIEF PRINTING CO., (800) 225-6964

OR CALL COLLECT (402) 342-2831

TABLE OF CONTENTS

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The Purpose of Chapter 11................

The Source of the Capital Contribution ....

The Form of the Capital Contribution .....

The Amount of the Capital Contribution... 11

Application to the Facts of This Case......

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TABLE OF AUTHORITIES

Cases

Butner v. United States, 440 U.S. 48 (1979)........... 11

Case v. Los Angeles Lumber Co., 308 U.S. 106 (1939). . passim

In re Bonner Mall Partnership, 2 F.3d 899 (9th Cir.

PPPPPPrrrerrTerrrry rr 18

In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977).... 17

Kham & Nate’s Shoes No. 2, Inc. v. First Bank, 908

F.26 1361 (7th Cie. 1000)... deccstsnnceunenaes 8, 9, 11

Northern Pacific Railway v. Boyd, 228 U.S. 482

(EDES) . co ccccccccccececes cach eu een 6

Norwest Bank Worthington v. Ahlers, 485 U.S. 197

|) Pr re 7,9

STATUTES AND OTHER AUTHORITIES

11 USC. § 1929. ....24.000000cnnen eee 2, 15

12 U.S.C. § 246. ....02000:05008000 5 en ennennnn 5

ideho Const. ast. ME, @ 9..055is0000eueee eee 19

Idaho Code §§ 30-1-18, 30-1-21........... 0.600 ccc eee 18

idaho Code § 30-1-89. . «.::s0cciesussecsbueeeeeal 19

Regulation Y, 12 CARR. 6 SURGE... ccccccnnnewemseasee 5

1 Model Business Corp. Act Ann. § 6.21 (3d ed.

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1 Model Business Corp. Act Ann. § 19 (2d ed.

3971)... scccccvccdes cteekeheaeeeeeneneaidaanuue 9, 10

iii

TABLE OF AUTHORITIES ~ Continued

Charles W. Adams, An Economic Justification for

Corporate Reorganizations, 20 Hofstra L. Rev. 117

SU DG CRebnSeraceceeeccnnseceseeececececseces

Frederick K. Beutel & Milton R. Schroeder, Bank

cer's Handbook = Commercial Banking Law

4-30, 5-30 (Sth ed.

Douglas G. Baird, The Initiation Problem in Bank-

ruptcy, 11 Int'l. Rev. L. & Econ. 223 (1991).....

Milton Harris & Artur Raviv, The Theory of Capital

Structure, 46 J. Fin. 297 (1991) ............0005.

John B. Levy, Regulations Prompt Higher Minimum

Spreads, 35 Nat'l Real Estate Investor 24 (Mar.

PREG UGRSSSUSNECEENsonccccdccecderccecceess

Lynn M. LoPucki & William C. Whitford, Patterns

in the Bankruptcy Reorganization of Large. Publicly

Held Companies, 78 Cornell L. Rev. 597

Bruce A. Markell, Owners, Auctions, and Absolute

Priority in Bankruptcy Reorganizations, 44 Stan. L.

eee chs ode es pene hons6hessesseere

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(1993) ..

Page

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. 16

Letters from the parties consenting to the filing of this

amicus curiae brief have been filed with the Clerk.

°

INTEREST OF AMICUS CURIAE

1 am not representing a client, and the views

expressed in this brief are my own. I have no monetary

interest in this or any other bankruptcy case. Aside from

wishing to assist the Court, my interests in this case are

entirely academic. I am a Professor of Law at The Univer-

sity of Tulsa College of Law, where I have taught courses

in creditors’ rights and bankruptcy. I am the author of An

Economic Justification for Corporate Reorganizations, 20

Hofstra L. Rev. 117 (1991). | had completed a forthcoming

article dealing with capital contributions in Chapter 11

reorganizations when the Court granted certiorari in this

case.

.

SUMMARY OF ARGUMENT

This brief supports the Respondent's position that

the Court should recognize a new capital exception to the

absolute priority rule. However, it is opposed to the

Respondent's plan of reorganization because the plan

does not appear to provide an adequate equity cushion in

the debtor's capital structure following reorganization.

Consequently, this brief is aligned with neither party.

The purpose of a Chapter 11 reorganization is to

repair an insolvent company’s dysfunctional capital

structure. It should not matter whether the new capital

, :

that an insolvent company needs for a successful reorgan-

ization comes from its creditors, outside investors, or its

former owners. What is critical to the reorganization is

the substance (i.e., the form and amount) of the new

capital contribution, rather than its source. In addition to

recognizing the new capital exception, the Court should

clarify the size of the capital contribution that is required.

The prevailing standard from Case v. Los Angeles Lum-

ber Co., 308 U.S. 106, 121-22 (1939), is unworkable. While

superficially plausible, the Los Angeles Lumber standard

turns out on closer analysis to be merely a tautology. It

should be replaced by a standard requiring an investment

of sufficient new capital that the reorganized company

will have a capital structure solid enough to withstand

future adversity without failing again. This standard

derives from the “feasibility requirement” in 11 U.S.C.

§ 1129%a)(11). Section 1129(a)(11) prescribes that a bank-

ruptcy court shall confirm a reorganization plan only if it

“is not likely to be followed by the liquidation, or the

need for further financial reorganization, of the debtor.”

.

ARGUMENT

I. The Purpose of Chapter 11

A bankruptcy reorganization is a process for restor-

ing financial health to an insolvent business through an

adjustment of its capital structure. Generally, the adjust-

ment involves the discharge of some debt and the infu-

sion of new capital from either outside investors, the

company’s creditors, or its owners.

3

A business normally is financed partly through

equity and partly through debt. Some equity is essential

in a company’s capital structure to capture the residual

interest in its future earnings. Most companies also have

substantial levels of debt financing. Besides offering a tax

benefit, debt in a company’s capital structure provides

leverage to owners, enabling them to earn a higher

expected return, though at greater risk.

Excessive debt, however, produces a risk of default

and a possible conflict of interest between the company’s

owners and its creditors. A conflict of interest may arise

because the owners are entitled to the profits if the busi-

ness succeeds, while the maximum return for the credi-

tors is the stated rate of interest. In a company where

most of the capital structure is debt with its owners

having only a small amount of equity invested, the

owners will have an incentive for excessive risk-taking.

The owners have everything to gain if a risky venture

succeeds, and nothing but their limited equity to lose if it

fails. The creditors, on the other hand, will continue to

earn only their fixed interest payments if the venture is

successful, while they risk nonpayment of the loan princi-

pal if it fails.

The risk of default and the potential conflict of inter-

est associated with a leveraged capital structure are nor-

mally held in check by the maintenance of a suitable

equity cushion. An equity cushion represents the owners’

stake in the enterprise, and the presence of a substantial

equity cushion insures that most of the risk is borne by

the owners, rather than the creditors.

An insolvent company has a pathological capital

structure. Because liabilities already exceed asset value,

an insolvent company’s owners have nothing more to

lose from further operating losses. Rather than maximiz-

ing the expected return from operations, the owners’

primary concern will be to have the business earn a

sufficient return so that it can become solvent again.

Because owners of an insolvent company bear none of the

downside risk, they will favor risky ventures with the

potential for large gains over others with more predict-

able, but smaller, gains. Until the business achieves sol-

vency, moderate gains will benefit only the creditors and

not the owners.

Unfortunately, both the creditors and owners of an

insolvent business lack incentives for maximizing its long

term interests. Insolvency generates destructive conflicts

of interests between the company’s owners and creditors,

with the owners seeking to have the business take exces-

sive risks and the creditors trying to collect as much on

their claims as they can through seizure of the company’s

assets. A company cannot operate effectively until these

conflicts are resolved. It is the resolution of these conflicts

through the restoration of a sound capital structure that is

the fundamental purpose of the bankruptcy reorganiza-

tion process. Charles W. Adams, An Economic Justification

for Corporate Reorganizations, 20 Hofstra L. Rev. 117,

117-38, 157-58 (1991).

Il. The Source of the Capital Contribution

There are only three potential sources of capital for

an equity cushion in a reorganized company: the com-

pany’s creditors, outside investors, and its existing

owners.

First, the company’s creditors may provide the neces-

sary capital through a conversion of some of their debt

into equity. A satisfactory capital structure can be

restored by discharging part of the debt (the portion

above the company’s going concern value) converting

some debt to equity to create an equity cushion, and

allowing the remainder to continue as debt in the reor-

ganized company. A major disadvantage of this approach

to reorganization is that it may not be feasible for some

creditors to become equity owners of the reorganized

business. Banks, for example, are a major source of debt

financing, and the Glass-Steagall Act, 12 U.S.C. § 24 (Sev-

enth), imposes significant restrictions on their ownership

of common stock. See Regulation Y, 12 C.ER.

§ 225.22(c)(1)(i) (bank holding companies may hold vot-

ing securities that are acquired in the ordinary course of

collecting a debt if they are divested within two years of

acquisition); Frederick K, Beutel & Milton R. Schroeder,

Bank Officer's Handbook of Commercial Banking Law §§ 4-30,

5-30 (5th ed. 1982).

Outside investors are an alternative source of new

capital for the equity cushion. Again, the portion of the

debt above the company’s going concern value will have

to be discharged with the remainder continuing as debt in

the reorganized company. In return for their new capital

contributions, the outside investors receive ownership of

the reorganized company, and their ownership interests

constitute the equity cushion. A major disadvantage to

this approach is that it may be difficult to find outside

investors willing to contribute capital to an insolvent

company.

A significant disadvantage to obtaining equity cush-

ion capital from either creditors or outside investors is

that these approaches offer no benefit to the existing

owners of the insolvent company, who lose control in the

reorganized company. In many cases, the existing owners

may be familiar with the business operations and have

been involved in managing the company; thus, the reor-

ganized company may be disadvantaged by the loss of

their association with it.

A more serious problem with these approaches is

that they offer the owners no reason to initiate the reor-

ganization process. If the company’s owners have no

incentive to file a reorganization proceeding, they will be

inclined to seek delay and to take increasingly risky

gambles hoping that solvency will be restored eventually

through some miracle. This is likely to lead to further

financial deterioration, to the point where recovery is no

longer possible. In theory, the insolvent company’s credi-

tors can file involuntary Chapter 11 proceedings if the

owners fail to do so. But in practice, creditors do not have

ready access to the company’s financial information, and

initiating an involuntary proceeding is difficult and risky

for them. See Douglas G. Baird, The Initiation Problem in

Bankruptcy, 11 Int'l Rev. L. & Econ. 223 (1991).

An additional justification for allowing participation

by the former owners in the reorganized company is that

they may be the best source of new capital. See Northern

Pacific Railway v. Boyd, 228 U.S. 482, 495 (1913). Unless the

owners are allowed to provide new capital for the reor-

ganizing company, the reorganization may fail and the

creditors could wind up receiving less in liquidation than

they would have under the plan. If the absolute priority

rule bars contributions of new capital from an insolvent

company’s owners, it could be detrimental to the inter-

ests of the very unsecured creditors it was designed to

protect.

Contributions of new capital from an insolvent com-

pany’s former owners should be encouraged, rather than

barred. Accordingly, this Court should recognize the new

capital exception to the absolute priority rule. At the

same time, the Court should require the form and amount

of the capital contributions to be sufficient to fulfill the

purpose of the Chapter 11 reorganization process by

restoring financial health to the reorganized company.

Ill. The Form of the Capital Contribution

In Norwest Bank Worthington v. Ahlers, 485 U.S. 197

(1988), this Court addressed the form required for a capi-

tal contribution if the new capital exeeption were to be

recognized. Following Case v. Los Angeles Lumber Co., 308

U.S. 106, 121-22 (1939), the Court held that capital contri-

butions would have to be in the form of “money or

money’s worth.”

The reorganization plan in Los Angeles Lumber called

for contributions from the reorganizing corporation’s for-

mer shareholders that consisted merely of their “financial

standing and influence in the community” and their pro-

viding “continuity of management.” Id. at 122. The Court

held that these intangibles were not adequate consider-

ation for the issuance of stock in the reorganized corpora-

tion, saying: “On the facts of this case they cannot

possibly be translated into money’s worth reasonably

equivalent to the participation accorded the old stock-

holders. They have no place in the asset column of the

balance sheet of the new company. They reflect merely

vague hopes or possibilities.” Id. at 122-23 (footnote omit-

ted).

The reorganization plan in Ahlers called for “yearly

contributions of labor, experience, and expertise,” 485

U.S. at 201, from the owners of a farm. As in Los Angeles

Lumber, the Court decided that these contributions of

future services were not sufficient to justify an exception

from the absolute priority rule. It reasoned:

Viewed from the time of approval of the plan,

respondents’ promise of future services is intan-

gible, inalienable, and in all likelihood, unen-

forceable. It “has no place in the asset column of

the balance sheet of the new [entity].” Los

Angeles Lumber, 308 U.S., at 122-23. Unlike

“money or money’s worth,” a promise of future

services cannot be exchanged in any market for

something of value to the creditors today. In fact,

no decision of this Court or any Court of

Appeals, other than the decision below, has ever

found a promise to contribute future labor, man-

agement, or expertise sufficient to qualify for

the Los Angeles Lumber exception to the absolute

priority rule.

Id. at 204 (emphasis in original) (footnote omitted).

In Kham & Nate’s Shoes No. 2, Inc. v. First Bank, 908

F.2d 1351, 1362-63 (7th Cir. 1990), the Seventh Circuit

confronted a type of capital contribution similar to one

offered in the reorganization plan in this case: a share-

holder guarantee of a loan to the reorganizing corpora-

tion. The plan of reorganization provided for the

corporation’s former shareholders to retain ownership of

the corporation in return for their guaranteeing new

loans that would finance the reorganization. Id. at 1354.

Relying on Ahlers and Los Angeles Lumber, the Sev-

enth Circuit ruled that the guarantees could not consti-

tute new value for purposes of satisfying a new capital

exception to the absolute priority rule. Judge East-

erbrook’s opinion for the court pointed out that guaran-

tees are not balance-sheet assets; instead, guarantees are

intangible, inalienable, and unenforceable, because there

is no way for a corporation to prevent shareholders from

revoking their guarantees or rendering them valueless by

disposing of their assets. The court also noted that per-

sons organizing a new corporation in Illinois could not

issue stock to themselves in return for guarantees of

loans, because Illinois law restricts the consideration for

new shares to money, property, or past services. Id. at

1362.

The Seventh Circuit made a useful comparison in the

Kham & Nate’s Shoes decision between on the one hand,

the problem of the form of new capital contributions in

the corporate reorganization context, and on the other,

the problem of “watered stock” and the form of capital

contributions required as consideration for the issuance

of stock under general corporate law. For many decades,

the trend in corporate law has been in the direction of

increasing liberalization of the form of allowed capital

contributions. 1 Model Business Corp. Act Ann. § 6.21

history (3d ed. 1989); 1 Model Business Corp. Act Ann.

§ 19 comment (2d ed. 1971). The Model Business Corpora-

tion Act (2d ed. 1971) provided:

“—

10

The consideration for the issuance of shares

may be paid, in whole or in part, in money, in

other property, tangible or intangible, or in labor

or services performed for the corporation. . . .

Neither promissory notes nor future ser-

vices shall constitute payment or part payment

for the issuance of shares of a corporation.

1 Model Business Corp. Act Ann. § 19 (2d ed. 1971).

The Revised Model Business Corporation Act (3d ed.

1989) broadens the allowable consideration to “any tang:

ible or intangible property or benefit to the corporation,

including cash, promissory notes, services performed,

contracts for services to be performed, or other securities

of the corporation.” 1 Model Business Corp. Act Ann.

§ 6.21 (3d ed. 1989). The Official Comment to Section 6.21

explains:

Section 6.21(b) specifically validates con-

tracts for future services (including promoters’

services), promissory notes, or “any tangible or

intangible property or benefit to the corpora-

tion,” as consideration for the present issue of

shares. . . . In the realities of commercial life,

there is sometimes a need for the issuance of

shares for contract rights or such intangible

property or benefits. And, as a matter of busi-

ness economics, contracts for future services,

promissory notes, and intangible property or

benefits often have value that is as real as the

value of tangible property or past services, the

only types of property that many older statutes

permit as consideration for shares.

11

Whether intangible property should be a permissible

form for a new capital contribution in a bankruptcy reor-

ganization should depend on the applicable state corpo-

rate law. See Butner v. United States, 440 U.S. 48, 55 (1979)

(in the absence of an overriding federal interest, property

rights in bankruptcy proceedings should be determined

by reference to state law). Thus, if the applicable state law

would permit a promise of future services (as in Ahlers)

or a shareholder guarantee (as in Kham & Nate’s Shoes or

this case) to constitute allowable consideration for the

issuance of stock in a corporation, then these forms of

intangible property should be permissible as capital con-

tributions, whether they come from a former shareholder

or an outside investor. Most states (including Idaho),

however, continue to follow Section 19 of the Model

Business Corporation Act (2d ed. 1971) and prohibit the

issuance of shares in exchange for such forms of intang-

ible property. See 1 Model Business Corp. Act Ann. § 6.21

annot. at 370-71 (3d ed. 1989) (listing states).

IV. The Amount of the Capital Contribution

The prevailing standard for the amount of the new

capital contribution in a plan of reorganization comes

from the following dictum in Case v. Los Angeles Lumber

Co., 308 U.S. 106, 122 (1939): “[T]he stockholder’s partici-

pation must be based on a contribution in money or in

money’s worth, reasonably equivalent in view of all the

circumstances to the participation of the stockholder.”

Because the shareholders’ contribution in that case was

not “in money or in money’s worth,” it was not in the

proper form, and the Court did not decide whether it was

“reasonably equivalent” to the value of the equity-the

shareholders were to receive under the plan. Thus, the

12

Court’s statement concerning the amount of the new

capital contribution was not part of the holding.

Although this standard appears reasonable, it pro-

vides no real guidance to courts, because it is a tautology.

See Bruce A. Markell, Owners, Auctions, and Absolute Prior-

ity in Bankruptcy Reorganizations, 44 Stan. L. Rev. 69,

96-101 (1991). Under the absolute priority rule, all of an

insolvent company’s value must be allocated to its credi-

tors; any debt in excess of its value as a going concern is

discharged. When new capital is contributed, the Los

Angeles Lumber dictum will be satisfied as a matter of

course, because the only value not allocated to the credi-

tors is the new capital contribution. As Professor Markell

notes, rather than placing any limits on the new capital

exception to the absolute priority rule, the Los Angeles

Lumber standard “merely rephrases the . . . rule.” Id. at

101.

In order to repair an insolvent company’s capital

structure in the course of the reorganization process, its

liabilities must first be written down to the going concern

value of the assets. At that point, the going concern value

of the company’s assets net of its liabilities is zero. The

going concern value of the company’s assets net of lia-

bilities may not be greater than zero, because if it were,

the creditors would be entitled to the excess as a result of

the absolute priority rule. A contribution of new capital

to the reorganizing company causes its going concern

value net of its liabilities to increase precisely by the

amount of the contribution. Since the contribution will

always be equivalent to the resulting going concern value

net of liabilities, the amount of the capital contribution

that is required in the reorganization process cannot be

determined from the company’s going concern value.

13

The indeterminacy of the Los Angeles Lumber stan-

dard may be demonstrated with a numerical example.

Consider the balance sheet of a company that initially has

assets with a going concern value of $1 million and

liabilities of $3 million. Writing down the liabilities to $1

million (the going concern value of the assets) would

yield a net going concern value of zero. If an owner or

other investor were to make a capital contribution of as

little as $5,000 after the writing down of the liabilities, the

going concern value of the company’s assets after the

contribution would be $1,005,000 and its net going con-

cern value would be $5,000. This is illustrated below.

Before Reorganization

Assets $1,000,000 Liabilities $3,000,000

Equity -2,000,000

Total $1,000,000 $1,000,000

After Reorganization

Assets $1,000,000 Liabilities $1,000,000

Shareholder

Contribution 5,000 Equity 5,000

Total $1,005,000 $1,005,000

An owner's contribution of new capital does not

vanish when it is made; instead, it increases the going

concern value of the reorganized company. The increase

in going concern value resulting from the infusion of new

capital may be even larger than the amount of the new

capital contribution, and over time, the participation of

former owners may contribute to the company’s going

14

concern value, particularly if they are involved in the

company’s management or operations.

Since the Los Angeles Lumber standard is fundamen-

tally unsound, it should be replaced with a better stan-

dard that is consistent with the purpose of the Chapter 11

reorganization process. The most appropriate criterion

for the size of the new capital contribution is that it

should be sufficient to provide an adequate equity cush-

ion. The price that the pew owners of a reorganized

business should be required to pay for control following

the reorganization is neither the going concern value

(which will initially be zero if the company’s assets are

valued correctly and the absolute priority rule is applied)

nor the amount of liabilities that are to be discharged.

Instead, the price should be that the new owners must

put up a sufficient stake in the enterprise to absorb any

future losses that can reasonably be anticipated, thus

reducing the risks to the creditors.

Absolute protection for a company’s creditors is not

attainable. No business is entirely risk free, and there is

always some possibility of future losses to creditors that

cannot be eliminated with any finite amount of equity

capital. Although creditors cannot expect to receive abso-

lute protection, they can be shielded from most risk of

loss through the maintenance of an adequate cushion of

equity. An adequate cushion of equity means the com-

pany’s owners will have appropriate incentives to maxi-

mize the long term value of the company, whether the

equity cushion comes from outside investors or from

tormer owners. The equity cushion ought to be large

enough, not only to keep the potential conflicts of interest

between owners and creditors to a minimum, but also to

absorb any fluctuations in earnings that can reasonably

15

be anticipated. Otherwise, there is too great a risk of

another insolvency, and the reorganization will have been

for naught.

To protect the company’s existing and future credi-

tors from a second insolvency, the “feasibility require-

ment” in section 1129(a)(11) of the Bankruptcy Code

provides that a bankruptcy court should confirm a reor-

ganization plan only if confirmation “is not likely to be

followed by the liquidation, or the need for further finan-

cial reorganization, of the debtor.” This requirement has

long been a part of the law of bankruptcy reorganiza-

tions. To determine whether a plan satisfies the feasibility

requirement, the courts normally look at whether there is

a reasonable prospect for the reorganization plan to be

successful. While the adequacy of a debtor’s capita! struc-

ture is often listed as one of the factors used in analyzing

a plan's feasibility, the bankruptcy courts have tended to

concentrate more on the accuracy of the plan's income

projections than on the need for the owners of the reor-

ganized company to have a significant stake in the enter-

prise.

The feasibility requirement cannot be satisfied if the

reorganized business is so thinly capitalized that it is

unable to withstand some future losses. The largest possi-

ble equity cushion would be provided by an all-equity

capital structure, but most companies operate satisfac-

torily with substantial levels of debt. The presence of debt

increases risk, but the reorganized company obtains off-

setting benefits from the tax advantages and leverage that

debt financing provides. And subject always to the stabil-

ity of the expected earnings for the reorganized company,

the risk of insolvency following reorganization can be

16

held to an acceptable level by maintaining an adequate

equity cushion.

A variety of factors may potentially influence a com-

pany’s capital structure. These include the company’s

profitability, the uniqueness of its products, the degree of

specialization of its equipment and its employees, and the

extent of equity ownership by its management. See Milton

Harris & Artur Raviv, The Theory of Capital Structure, 46 J.

Fin. 297, 337-40 (1991) (summarizing theoretical and

empirical studies on the effect of these and other factors

on a corporation's capital structure). However, the pri-

mary factor affecting a company’s capital structure is

generally the volatility of its earnings. A number of

studies have shown, for example, that corporations in

regulated industries, which tend to have stable earnings,

have the highest proportions of debt, while pharmaceuti-

cal and electronics manufacturers, which tend to have

volatile earnings, have the smallest proportions of debt.

Id. at 333-35. Therefore, the capital structures of other

companies in the same industry may provide a gauge for

a bankruptcy court to use in evaluating the adequacy of a

proposed equity cushion in a reorganization plan. Cf.

Lynn M. LoPucki & William C. Whitford, Patterns in the

Bankruptcy Reorganization of Large, Publicly Held Com-

panies, 78 Cornell L. Rev. 597, 607-09 (1993) (companies

emerging from reorganizations tend to have higher debt-

to-equity ratios than companies of comparable size in the

same businesses).

Although there may not be any precise formula for

determining an ideal capital structure for a reorganized

company, in many cases a bankruptcy court can be rea-

sonably certain that a capital structure proposed in a plan

under review is inadequate. For example, it is clear that a

17

business should not be allowed to emerge from the reor-

ganization process without any equity cushion. For closer

cases, the bankruptcy court may need expert testimony

from a financial analyst concerning the adequacy of cap-

italization and possibly also from a lender as to the

likelihood of the debtor being able to borrow the debt

provided for in the plan from an informed outside source.

See In re Mobile Steel Co., 563 F.2d 692, 703 (5th Cir. 1977)

(listing methods for determining the adequacy of capital-

ization in equitable subordination cases).

The adequacy of the capital contribution proposed in

this case is addressed below.

V. Application to the Facts of This Case

In this case the debtor’s primary asset is a shopping

mall in Idaho, which the bankruptcy court valued at $3.2

million. Its major liability is a loan of $6.6 million secured

by a deed of trust against the mall. The debtor’s plan

provides for repayment of the secured portion of the loan

($3.2 million) 32 months after confirmation with interest

payable monthly in the interim. Unsecured creditors with

claims greater than $1,000 will receive a pro rata distribu-

tion of 300,000 shares of preferred stock, which has a par

value of $1.00 per share and is convertible to a maximum

of 300,000 shares of common stock upon repayment of the

secured portion of the loan. The preferred shares will

have a liquidation preference over the common stock. The

debtor's six former partners together are to contribute

cash of $200,000 and will receive 2 million shares of

common stock in return. In addition, the plan calls for the

partners to subsidize any shortfall in working capital

during the first 32 months after confirmation of the plan

18

and for five of the former partners to contribute a collat-

eral trust mortgage on other property as a guarantee of

the debts that are being assumed by the reorganized

business. See In re Bonner Mall Partnership, 2 F.3d 899, 905

(9th Cir. 1993).

It is apparent that the reorganized corporation would

be too thinly capitalized to satisfy the feasibility require-

ment. Even though the reorganized corporation would

not be immediately insolvent if the plan were confirmed,

the common shareholder's equity interest would be

“under water” on account of the issuance of the 300,000

shares of $1.00 par value preferred stock to the corpora-

tion’s former unsecured creditors. The issuance of the

preferred shares would therefore violate the stated capital

requirements of applicable Idaho law. See Idaho Code

§§ 30-1-18, 30-1-21 (1980) (prohibiting the issuance of

shares for less than their par value). With only a $200,000

equity cushion, the common shareholders would not be

entitled to any profits until the $100,000 impairment of

capital resulting from issuance of the preferred stock was

cured. Consequently there is a potential conflict of inter-

est between the common and preferred shareholders built

into the capital structure of the reorganized corporation.

The Bonner Mall plan is also deficient on account of

the size of the equity cushion. There are a number of

factors that affect the size of a real estate loan, but most

lenders require at least a 75% loan to value ratio:

Since the beginning of the commercial mortgage

business, lenders have imposed a 75% loan-to-

value limit as being prudent. This real estate

recession has unfortunately shown that even

that level of leverage was too aggressive. As a

result, a number of survey members are now

19

requiring that their commercial mortgages meet

a 65% loan-to-value test or less.

John B. Levy, Regulations Prompt Higher Minimum Spreads,

35 Nat'l Real Estate Investor 24 (Mar. 1993). Cf. 79 Fed.

Reserve Bull. A37 (Sep. 1993) (loan-to-value ratios for

mortgages on new homes ranged from 74.8% to 79.5%

between 1990 and June, 1993). An appropriate equity

cushion for the secured creditor’s $3.2 million claim

might therefore be in the neighborhood of $1 million,

instead of the $200,000 called for in the reorganization

plan.

The plan also calls for the former partners to subsi-

dize any shortfall in working capital and to guarantee the

payment of the reorganized corporations with a | olladeral

trust mortgage. Depending on the circumstances, these

guarantees might have sufficient value to compensate for

the lack of a more substantial cash contribution. How-

ever, they would not be allowed as consideration for the

issuance of new shares under applicable Idaho law. See

Idaho Const. art. XI, § 9 (“No corporation shall issue

stocks or bonds, except for labor done, services per-

formed, or money or property actually received; and all

fictitious increase of stock shall be void.”); Idaho Code

§ 30-1-19 (“The consideration for the issuance of shares

may be paid, in whole or in part, in cash, in other prop-

erty, tangible or intangible, or in labor or services actually

performed for the corporation.”). Thus, they should not

be considered part of the equity cushion of this reor-

ganized corporation.

Accordingly, the reorganization plan does not satisfy

the feasibility standard and should not be confirmed.

20

Even if this Court concludes that the record is not

sufficiently clear to decide on confirmation of the reor-

ganization plan, the Court should specify the standard

clearly enough for the lower courts to apply. The stan-

dard should be based on the capital structure of the

reorganized company having an equity cushion that is

adequate to withstand reasonably foreseeable variations

in future earnings. The adequacy of the equity cushion

may be determined by comparison to the capital struc-

tures of similar businesses and from testimony of finan-

cial experts.

CONCLUSION

Inseparable from the issue of whether a new capital

exception to the absolute priority rule should exist is the

question of what its parameters should be. In addition to

recognizing this exception, this Court should enunciate

reasonable standards for the form and amount of the new

capital required for confirmation of a reorganization plan.

Respectfully submitted,

CuHarites W. AbAms

Professor of Law

The University of Tulsa College

of Law

3120 East Fourth Place

Tulsa, OK 74104

(918) 631-2437

Amicus Curiae