Business Law 2

Equity Committees Protect Shareholders in Chapter 11 Reorganizations of Publicly-Held Companies
by Thomas Henry Coleman

Thomas Henry Coleman, Troy and Gould Professional Corporation, Los Angeles, contributing author of Advising and Defending Corporate Directors and Officers, published by CEB. The firm’s website address is www.troygould.com and Mr. Coleman can be reached by e-mail at thcoleman@troygould.com.

Why Are There Equity Committees?

At first glance, the lot of shareholders in Chapter 11 reorganization cases of large, publicly-held companies seems bleak. Fortunately, the Bankruptcy Code (“Code”) provides a champion for these shareholders—the official committee of equity security holders (“Equity Committee”). By collectively representing all shareholders, the Equity Committee and its professionals provide shareholders with meaningful access to the reorganization process and an equal opportunity with creditors to preserve their financial interests. See Lynn M. LoPucki & William C. Whitford, Bargaining Over Equity’s Share in the Bankruptcy Reorganization Process, 139 U Pa L Rev 124, 158-59 (1990); and Thomas Henry Coleman & David E. Woodruff, Looking Out for Shareholders: The Role of the Equity Committee in Chapter 11 Reorganization Cases of Large Publicly Held Companies, 68 Am Bankr LJ, 295 (1994).

Unlike Creditors’ Committees, whose appointment the Code requires in every Chapter 11 case, Equity Committees were relatively rare until recently. See 11 USC §1102(a) (2002). However, they are now more numerous, the result of a new wave of Chapter 11 “mega-cases,” involving large, publicly traded debtors, in which Equity Committees may represent large numbers of shareholders and huge collective interests.

The Equity Committee’s Role

Section 1103(c)(1) of the Code emphasizes the fact that Equity Committee participation in the case should be an interactive process involving regular communication with the trustee or debtor in possession. This is because in practice out-of-court communication and negotiation of issues between the Equity Committee, the debtor, and other parties, is usually much more efficient than litigation in court.Section 1103(c)(2) and (3) of the Code identify the key activity for the Equity Committee: participation in the plan process. These clauses allow the Equity Committee full involvement, including a “due diligence” type investigation of the debtor’s financial affairs, negotiation of plan terms, and participation in plan confirmation. Section 1121(c) of the Code provides that an Equity Committee, subject to the debtor’s exclusivity rights, may file a plan or reorganization.

Solvency as a Factor Supporting the Appointment of an Equity Committee

Solvency, even if only marginal, is usually a primary factor in the decision to appoint an Equity Committee although in the current wave of mega-bankruptcies an Equity Committee may be appointed even if the debtor is insolvent. The appointment of an Equity Committee and its inevitable employment of professionals typically creates a significant cost burden for the estate. This additional cost must be weighed against the need for adequate representation of shareholders. See In re Wang Laboratories, Inc. (Bankr D MA 1992) 149 BR 1, 4; In re Beker Industries Corp. (Bankr SDNY 1985) 55 BR 945, 950-51; In re Emons Indus. Inc. (Bankr SDNY 1985) 50 BR 692, 694; Collier on Bankruptcy, 1102.02 Allan N. Resnick et al. eds., (15th ed rev 2001).

Where the debtor clearly is insolvent, the need to avoid unnecessary cost would in most instances appear to outweigh the need for adequate representation of shareholders. As a legal matter, there is little an Equity Committee can accomplish in such a case because shareholders of a clearly insolvent debtor are entitled to nothing. However, where the debtor is even questionably solvent, or perhaps insolvent, shareholders have a meaningful interest in the outcome of the case, and should have the benefit of Equity Committee representation, despite the cost. See In re Wang, 149 BR at 3; In re Beker, 55 BR at 950-51.

Determining the debtor’s solvency can be difficult. Early in the case, when the appointment of an Equity Committee usually is considered, a reliable analysis of the debtor’s solvency on a reorganization basis probably will not be available. In any event, the proponents of an Equity Committee will likely lack the information and resources to conduct such an analysis.

The Goals of the Equity Committee

The Equity Committee should evaluate courses of action in the case in light of two fundamental goals. The first of these goals is to maximize the consideration received by shareholders under a plan of reorganization. The consideration offered to shareholders is almost always some form of equity in the reorganized debtor which usually takes the form of common stock, but can also include more exotic forms of equity such as warrants or preferred stock. This goal really boils down to negotiating or otherwise obtaining the largest possible share of such equity for present shareholders.

The second goal is to maximize the overall value of the equity in the reorganized debtor, which in turn maximizes the value of the share of such equity received by present shareholders. This involves monitoring the case and taking action where necessary to ensure that: (a) the debtor is doing everything possible to maximize profitability; (b) the debtor is obtaining maximum value for assets (including causes of action); (c) creditor claims are being minimized; and (d) the least possible amount of assets is being allocated to satisfy creditor claims.

Strategies for Achieving these Goals

Negotiations

As previously discussed, the paramount goal of the Equity Committee should be to maximize the share of equity received by shareholders under the plan. Although a legal framework exists for determining entitlement of shareholders to a share of the reorganized debtor’s equity, determination of this share typically does not boil down to a legal battle. More often, the issue is resolved consensually through a series of negotiations. The success of the Equity Committee in these negotiations depends upon its effective utilization of “pressure points” on the debtor and creditors.

Pressure Points

These pressure points can take many forms. Some examples include:

• The need for a consensual and quickly confirmed plan. The presence of an Equity Committee can be a dangerous obstacle that can lead to concessions for shareholders.
  
• The avoidance of the cost and risk of litigating the entitlement of shareholders to receive a share of the equity.
  
• Worries of the debtor’s directors and management about fiduciary obligations to shareholders. The Equity Committee can increase this pressure by requesting (or threatening to request) the court to compel the calling of a shareholders’ meeting for the purpose of voting on the continued service of the directors (and by implication the continued service of management). See Manville Corp. v. Equity Sec. Holders Comm. (In re Johns-Manville Corp.) (1986) 801 F2d 60 (denying motion for summary judgment in action by debtor to enjoin Equity Committee’s state court action to compel shareholders’ meeting); Official Comm. of Equity Sec. Holders of Lone Star Industries v. Lonestar Indust., Inc. (In re New York Trap Rock Corp.) 138 BR 420 (Equity Committee has standing to seek to compel debtor to hold shareholders ‘ meeting); In re First Capital Holdings Corp. (Bankr CD Cal. 1992) 146 BR 7 (authorizing Creditors’ Committee to prosecute claims on behalf of debtor against debtor’s officers and directors). The Equity Committee can also attack the management based upon past activities (e.g., an ill-advised leveraged buy-out).
  
• The desire of creditors to avoid an investigation into and possible litigation over matters such as lender liability, improper claims trading, or other improper activities.
  
• In high profile cases, the desire by management and major creditor groups to appear to be publicly magnanimous.
• The need of the debtor’s management to enlist the support of the Equity Committee for their executive compensation, stock options, and like plans, and to avoid Equity Committee criticism of management “perks.”
  

The Threat to File a Competing Plan of Reorganization

If the debtor and creditors cannot be dissuaded from attempting to confirm a plan highly unfavorable to equity, the Equity Committee may have no choice but to urge shareholders to vote against it, and to object to confirmation of the plan.

The most likely target for objection is the requirement of §1129(a)(8) that each impaired class of claims or interests vote to accept the plan. If, under the plan, shareholders are not retaining their 100% ownership of the debtor, the class of shareholders is impaired. See 11 USC §1124. All that is needed for that class to fail to accept the plan is for over one-third of voting shareholders in that class to vote to reject it. See 11 USC §1126(d). This result usually can be achieved by mailing letters to all shareholders urging them to vote against the plan. Because shareholders also will receive a court-approved disclosure statement from the plan proponent, the Equity Committee probably does not need court approval to send such a letter. See Century Glove, Inc. v First Am. Bank of New York (3d Cir 1988) 860 F2d 94 . However, to avoid administrative burden and cost and for greater effectiveness, the Equity Committee may want to ask the court to require that such a letter be included in the plan and that a disclosure statement package is sent by the plan proponent.

The failure of §1129(a)(8) voting requirement does not by itself defeat plan confirmation. Section 1129(b) allows the court to “cram down” a plan otherwise meeting the requirements of §1129(a) on a dissenting class of shareholders if the plan does not discriminate and is “fair and equitable” to such class. See 11 USC §1129(b).

Reorganization Value

Where the property to be distributed to creditors is a share of the equity in the reorganized debtor, a valuation of such equity must be performed to determine if its value exceeds the allowed amounts of creditor claims. Such equity is valued according to its “reorganization value.” This is the future value of the equity once the reorganization plan has been implemented. If the reorganization value of the equity to be distributed to creditors exceeds the allowed amounts of their claims, the plan violates the prohibition on more than 100% payment and cannot be confirmed. To be confirmed, the plan must be modified to give shareholders this excess equity value. See Consolidated Rock Prods. Co. v Du Bois (1941) 312 US 510; Fortgang & Mayer, Valuation in Bankruptcy, 32 UCLA L Rev 1061, 1126-30 (1985).

Conclusion

Appointment of an Equity Committee, and its full and meaningful participation in the reorganization process, provides shareholders with at least a fighting chance to salvage their interest in a corporation. Further, allowing shareholders to be represented by an Equity Committee promotes the Chapter 11 policy in favor of consensual reorganization through negotiations among major constituencies.

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