essay questions spring 2004 bus reorg

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Business Reorganization in Bankruptcy-Essay Portion






PROFESSOR Scarberry TIME: Two (2) Hours ____________________________________________________________________________ INSTRUCTIONS 1. This portion of the exam consists of two one-hour essay questions. These two essays together will count as two-thirds of your final examination grade. The multiple choice section will count one-third. 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. Please use blue or black pen only (unless you are typing or using ExamSoft), and start each question in a separate bluebook.





Essay 1 — One Hour DimCo, a manufacturer of sunglasses, failed to keep up with the latest styles. As a result, its sales dropped substantially during 2003, and it ran short of cash. DimCo managed to meet its obligations to suppliers by borrowing $100,000 from Bay City Bank in late 2003. The Bank did not ask DimCo for collateral but did demand that DimCo’s sole shareholder, Georgette, guarantee the loan and give the Bank a security interest in her DimCo shares to secure the guarantee. Georgette did so. A few months later DimCo once again ran short of cash, and this time it could not find anyone to lend it additional funds. DimCo then defaulted on the loan from the Bank by failing to make a payment that was due on April 12, 2004. Eight days later, on April 20, DimCo filed a chapter 11 petition. As the terms of the guarantee agreement permitted, on April 21 the Bank demanded that Georgette pay it the entire $100,000 (plus accrued interest) immediately. Georgette refused, noting that she planned to lend the few thousand dollars she had in her savings account to the debtor in possession DimCo to assist with the reorganization. The Bank then contacted Acme Corporation, which the Bank knew was interested in getting into the sunglasses manufacturing business. The Bank suggested a ―course of action.‖ The Bank would foreclose on Georgette’s stock, buy the shares at its own auction, vote the shares to replace DimCo’s board of directors, and then cause DimCo to sell its business assets to Acme in a section 363(b) nonordinary course sale; the Bank (or DimCo) would then propose a liquidating plan under which DimCo would pay out the cash received from Acme to DimCo’s creditors, including the Bank. Acme said it was interested in buying DimCo’s assets, and on May 4 the Bank gave Georgette notice (as required under U.C.C. Article 9) of the foreclosure auction date, set for June 7, 2004. On May 5 DimCo began an adversary proceeding by filing a complaint in the bankruptcy court seeking a declaration that the Bank would violate the automatic stay if it foreclosed on Georgette’s shares in DimCo or otherwise attempted to collect the debt from Georgette. The complaint also included an alternative count in which DimCo sought a section 105(a) injunction temporarily enjoining any such actions by the Bank. On May 7, Georgette lent debtor in possession DimCo $10,000; by signed, written agreement DimCo granted Georgette a security interest in all of DimCo’s assets to secure the loan and also agreed that she would have a superadministrative priority for the $10,000, ahead of all other administrative expenses. On May 8, Acme bought three prepetition unsecured claims that suppliers had against DimCo, one for $5,000 (for raw plastic sold to DimCo), one for $7,000 (for tinted lenses sold to DimCo), and one for $3,000 (for packaging materials sold to DimCo). On May 9, at the Bank’s request, Acme signed ballot forms indicating that it was voting its three purchased claims to accept the Bank’s suggested liquidation plan, if and when such a plan should be filed by the Bank or by DimCo. It is now June 5, 2004. The Bank timely answered DimCo’s complaint. You are the bankruptcy judge. Please discuss how you will decide the following issues that may come up in the adversary proceeding or in later hearings in DimCo’s bankruptcy case.



Did the Bank violate the automatic stay on April 21 by demanding payment from Georgette?

No, it is not an attempt to collect a debt against the debtor, and it isn’t really going to have that much effect on the bankruptcy case because if the guarantor has to pay, the only thing that happens is the guarantor has a claim in the bankruptcy case instead of the bank having a claim. This is not like Robbins case where there was a disputed claim and where the result of the suit against the people who allegedly owed the debt could covert a disputed claim to an undisputed claim. So AH Robbins would have to jump in a defend the suit even though they were not a claimed party. But here there is no disputed claim, no one doubts the money is owed and there will be no major change if the bank has a claim or if G has a claim. Are Georgette’s shares of DimCo stock property of the estate in DimCo’s chapter 11 case? Would the Bank violate the automatic stay simply by foreclosing on Georgette’s shares of DimCo stock?


Was that stock DimCo’s property and there for property of the estate? No, G owns the stock, the stock is not property of the estate, therefore the attempt to foreclose on the stock is not an attempt to foreclose on property of the estate and thus does not violate the automatic stay. Second question, the answer is no. Maybe the whole course of conduct has the effect of taking control of property of the estate, but the question asks about simply foreclosing on the stock, and that does not violate the stay.


Would the Bank violate the automatic stay if it carried out (or attempted to carry out) the ―course of action‖ that it described to Acme?

By foreclosing on the stock the bank wants then to have the ability to vote the stock to replace the directors who would then propose a sale under 363(b) of the assets of the estate to Acme. Arguably, this whole course of conduct is designed to exercise control over property of the estate. The question is then, ―if each step of a course of action does not violate the automatic stay, cant the sum of all those steps violate the automatic stay?‖ Some courts would be concerned about this. On the other hand, here you have a creditor who would like to get paid and is coming up with an alternative way to realize value and is in essence abiding by the rules, on the other hand, if the directors that would be voted in would simply have as their goal selling the assets to Acme, then that is probably not admissible because those directors have fiduciary obligations to all creditors and stockholders and they can’t just come in with the intent of accomplishing some private goal. So maybe not all steps are permissible and it would violate the stay.



Thinking ahead, you wonder what might happen if the Bank became the owner of the DimCo shares as a result of a foreclosure, without violating the automatic stay or any other court order or statute. If that were to happen, would you permit the Bank to vote the shares to replace the DimCo board of directors with new directors (that is, with directors who would be committed to selling DimCo’s assets to Acme and then liquidating DimCo)?

This should remind us of the Maneville case, the court said ordinarily the shareholder does have a right to chose directors. However, if you are choosing directors with the intent of destroying the possibility of reorganization it would be a clear abuse of the shareholder’s powers. The directors would have to be willing to look at the situation and determine what is in the best interest of the estate and all the creditors and all the shareholders. So in this case it is probably a clear abuse and the court should not allow it.


Will you grant the requested section 105(a) injunction?

First off, are you going to protect G. She has already contributed money by making a DIP loan. There is no clear indication that she is going to make any more loans. There is an argument that when a court protects a guarantor to allow the guarantor to put more money into the estate then the court is basically facilitating a fraudulent transfer because the guarantor is flushing money away, giving it to an insolvent company and becoming judgment proof. That hardly seems equitable. But here there is no indication that G is going to contribute more, and there is no indication that the collection from G is going to prevent her from spending time on the reorgaziation. It will probably be a quick summary judgment against her. Some courts may say that she won’t be able to concentrate if she is worried about the lawsuit against her. Scarberry thinks that is wrong. With regards to the other 105 injunction to prevent the foreclosure sale of the stock, it depends on what the court thinks the bank is going to do with its power once it forecloses on the stock. The court will probably allow the foreclosure to occur but will withhold judgment on whether the new owner of stock would be able to replace the board. If that was an abuse then stop it at that point.



What are Georgette’s rights with regard to the $10,000 she lent to debtor in possession DimCo? Did DimCo have the power to grant her the security interest and priority provided for in the written agreement?

Notice that she lent the money with no indication with notice or hearing or court order authorizing this. If this was an ordinary course transaction (incurring of debt by DimCo) then there is not need for this, but the borrowing is probably not ordinary course, we don’t know what they have done in the past, we don’t know if this is a typical thing, we don’t know what similar companies do. If it is ordinary course then under 364(a) it would have a plain old administrative expense priority associated with it. But she purports to have her corporation give her a superpriority status and a lien on all of DimCo’s assets. That would have to be under 364(c). Under 364(c) you first have to show you could not get the credit elsewhere and there is no indication of that, they have to try or make a showing that it would have been useless. There is indication that no one wanted to lend more money to DimCo, but they were not in bankruptcy yet so it is a new situation. So the bottom line is there was no indication that there was an attempt to get credit just on a plain old administrative expense basis. In addition under 364 the court may authorize it but is has to be after notice and a hearing, and there is not info that there is notice and a hearing here. That would mean that she is not entitled to a superpriority claim or a lien.


If and when a liquidating plan is filed and voted on, will the ballots that Acme executed on May 9 be valid acceptances?

What has to happen before you can solicit acceptances or rejections of a plan? Disclosure statements have to transmitted to the creditors. There hasn’t even been a proposed plan filed. Now it is true that before the bankruptcy petition is filed it is possible to give disclosures that are the equivalent of disclosure statements and go ahead and get people to sign ballots and get acceptances, that is called a pre-packaged Chapter 11. But once the petition has been filed you can not any more solicit acceptances until a disclosure statement has been approved by the court and transmitted to the creditors, so this solicitation was improper and are invalid.


Essay 2 — One Hour Delphi Limited Partnership (Delphi) has a very wealthy general partner, Gus, who invested a small part of his wealth—$1 million—in Delphi. Delphi also has 37 limited partners, each of whom invested $100,000 in Delphi. Delphi borrowed $50 million from Friendly Finance Company (Friendly) on a nonrecourse basis for purposes of purchasing land and constructing an amusement park with an ―Ancient Greece‖ theme. The $50 million loan was secured by a properly recorded mortgage on the real property (including of course the amusement park rides and buildings Delphi constructed on the land). Unfortunately, Delphi ran out of money before the amusement park was quite completed. Also unfortunately, an economic downturn has hurt all the amusement parks in the area. Delphi’s real property valuation expert estimates that the unfinished amusement park is worth about $30 million. She also says that if Delphi can find the $2 million needed to finish it, it will probably be worth about $37 million. Friendly refused to lend Delphi anything more, and no one else would lend Delphi the needed $2 million. With the amusement park unfinished, Delphi had no source of cash to make payments on Friendly’s mortgage, and Friendly was threatening to foreclose. Thus Delphi filed a chapter 11 petition. Delphi has only four creditors other than Friendly. One supplier of building materials is owed $200,000. Three construction companies are owed $100,000 each. Neither the supplier nor any of the three construction companies took the needed steps to obtain mechanics’ or materialmen’s liens on the real property; thus the $500,000 total debt owed to them is all unsecured. Delphi’s assets consist of the real property that is Friendly’s collateral, and a few items of personal property worth about $250,000 total. Gus and twenty of the limited partners are each willing to contribute another $100,000, for a total of $2.1 million ($2,100,000). They say they will do so only pursuant to a plan of reorganization that will give them 100% of the ownership of the reorganized Delphi. Delphi therefore proposes the plan that is set forth immediately below. Assume (unrealistically!) that administrative expenses in the chapter 11 case are so small that they can be ignored. Also assume that Friendly will oppose the plan and will not make the section 1111(b)(2) election. Assume the court determines that 6% annual interest is a fair market rate for the mortgage that the Class 1 claim holder will receive. Assume the building materials supplier and the three contractors will all accept the plan, but that several of them would not accept the plan if it provided them with less value. Also assume that, at Delphi’s request, the court has terminated exclusivity.
Summary of Proposed Plan of Reorganization Class 1 will consist of Friendly’s $30 million secured claim. Friendly will receive a first mortgage on the real property for the amount of the secured claim plus (commencing on the effective date of the plan) 6% annual interest. Payments on the mortgage will begin two years after the effective date of the plan. Because interest will not be paid during the first two years, interest in the amount of $1.8 million for each year will be added to the $30 million principal amount of the mortgage. Thus, when payments commence, the principal amount of the mortgage will be $33.6 million. That amount will be paid off with 6% annual interest over the succeeding 30 years by equal monthly payments. In addition, the reorganized Delphi will spend at least $150,000 per month, beginning with the effective date of the plan, to finish the amusement park, until it is finished and open for business.


(Note that over the first year that will be at least as much as the $1.8 million of accruing unpaid interest.) Should Delphi fail to do so in any month, Friendly may immediately foreclose. Class 2 will consist of the $500,000 in general unsecured claims held by the building materials supplier and the three contractors. Holders of these claims will receive 20% of their claims in cash on the effective date of the plan, and promissory notes for another 30% of their claims. The promissory notes will carry an interest rate of 5%, but interest will not begin to accrue until two years after the effective date of the plan. The notes will be paid in sixty equal monthly payments beginning two years after the effective date of the plan. Class 3 will consist of Friendly’s $20 million unsecured claim. On account of this claim Friendly will receive a promissory note for $1.4 million, with the same terms as the promissory notes to be received by holders of Class 2 claims. Class 4 will consist of the interests of the existing general and limited partners of Delphi. Their interests will be canceled and they will neither receive nor retain any property on account of such interests. Gus and twenty of the limited partners each will contribute $100,000 to the reorganized Delphi, in return for which they will receive 100% of the ownership of the reorganized Delphi. Of the $2.1 million total to be contributed, $100,000 will be used to make the cash payment to holders of Class 2 claims on the effective date of the plan. The other $2 million will be used to complete the amusement park so that it can open for business and generate the revenue to pay the mortgage and the promissory notes referenced above.

Please discuss the following questions: 1. If one of the Class 2 claim holders had decided to reject the plan, how much value would the plan have had to provide to that claim holder in order to satisfy the best interest of creditors test?

1129(a)(7) – at least as much value as the creditor would receive in a Ch. 7 Liquidation. In a Ch. 7 liquidation the mortgagee would take all the value of the real property, but there would be $250K of value in personal property that the mortgagee doesn’t have a lien on. What would be the amount of unsecured claims in a Ch. 7 liquidation? It would be only $500,000 because the mortgagee does not have an unsecured claim the loan was non-recourse. Ignoring administrative expenses the creditors would get about 50%. Another question would be ―what if 3 of the 4 creditors accepts and the other one (a guy with a $100K claim) does not?‖ So it’s 400K for and 100K against. The class accepts because it is more than 2/3rds in amount, must be more than 333K and here we have 400K accepting. And more than half in number accept. This is assuming all of them vote. But the best interest of creditor test still applies to protect a dissenting creditor in a class that accepts, so he would have to get 50% in value. The plan does not give 50% in real value because the notes have no interest for 2 years and the rate is lower than the FMV for notes on a secured claim and these are unsecured, so that 30% in notes is not really worth 30%. Remember, if the creditor is not impaired then they don’t get the benefit of that test, but that is a ridiculous situation.



Must the plan be fair and equitable with respect to Class 1 to be confirmed? Is the plan fair and equitable with respect to Class 1?

Here Class 1 is rejecting the plan. A dissenting class is entitled to the protection of the fair and equitable standard. Now, is it fair and equitable? The requirements under 1129(b)(2)(A)(i) says you have to keep a lien in the amount of your secured claim and you must get cash payments equal to the amount of the present value of your secured claim. Here the lien is for 30 mil which is the amount of the secured claim, and here the payments are paid with a 6% rate. If that is the appropriate market rate, which the court has determined it is, then you have appropriate present value. This means that the explicit requirements of Fair and Equitable are satisfied, what may not be satisfied is the general requirement that the plan must be Fair and Equitable beyond what is specifically listed in 1129. So we have to look at Oaks Partners which is a negative amort. case. Here the negative amort. goes on for 2 years. It is not as long as the court allowed in Oaks Partners. How much is the negative amort.? Here it is 3.6 million. That is more than 10 percent extra that is going to be put at risk. If they are forced to foreclose after 2 years they are going to need to get 33.6 million. That is a lot of extra money. Go through the factors. 1) Does the plan offer market rate of interest? Yes; 2) Is the amount and length of the proposed deferral reasonable? The length seems ok, but the amount seems high; 3) Is the ratio of debt to value satisfactory throughout the plan? It is not clear. The point is to get the extra value in finishing the property, if it never gets finished then that could be a poor use of money, there is probably not much value added by each month of work completed, until it is completed. 4) Are the debtor’s financial projections reasonable and sufficiently proven? We don’t really know about it. 5) Are the risks being unduly shifted to the creditor? Are they the only ones being asked to take a risk? Not really, the old owners are putting in new money and that is at risk as well. 7) Does the plan preclude the secured creditor’s foreclosure? Not really, is says if they don’t do what they say they are going to do, bingo, immediate foreclosure. 8) Do the original loan terms provide for negative amort.? Probably not, but that shouldn’t be a huge factor. 9) Are there safeguards to protect the secured creditor against plan failure? Doesn’t seem like a lot except what is here. Scarberry would argue that it is not Fair and Equitable because the dollar amounts are too high, but it could go either way.


Must the plan be fair and equitable with respect to Class 3 to be confirmed? Is the plan fair and equitable with respect to Class 3?

Sure, it is an impaired class that has rejected the plan. Is it Fair and Equitable? There is no way you are giving them 100% on their unsecured claim so you have to provide that no holder of a claim in a junior class receives or retains any property on account of their junior claim or interest. Here the old owners are giving new money and they are getting the ownership of the reorganized business in exchange for that new money. Under BofA v. LaSalle we have to ask if there is enough of a causal connection here to say they are getting it on account of their old interests. Well, here the court has terminated exclusivity, so if someone thinks the old owners are getting a sweetheart deal then someone else can propose a plan. On the other hand, this plan may be a ways down the tracks and it may be hard for someone else to propose a plan and have it heard in time. So the court should see if someone else wants to propose a plan, and if so, then 9

hold up confirmation of this plan so there can be some competition. But it is possible that termination of exclusivity allows for the kind of competition that could justify saying that the old owners are getting their new ownership interest on account of the new value they are putting in. This assumes the new value exception exists, which is still a question. But if it does, there has to be 1) New value (they are putting in new cash money); 2) Money or monies worth (this is cash); 3) It has to be substantial (here it is a couple million dollars); 4) Is it necessary (without this cash you can’t finish the project and if you can’t finish the project you can’t reorganize; 5) Are they getting a sweetheart deal (we don’t have enough facts, if they finish the project should be worth 37 million, the debts will be 33.6 million in mortgage and about 1.5 million in promissory notes. So we are talking about 35 million in debts and the property is worth 37 million, so they are paying a fair price for it)


Is there a reasonable basis for separately classifying Friendly’s unsecured claim in Class 3?

Depends on who you talk to. All of the circuits except the Woodbrooks circuit (7th) have said you cannot separately classify the deficiency claim of the under-secured mortgagee. Most of the circuits say you can not do this. On the other hand, if you have to put them together then there is no way you can give as much value to the trade creditors. If you put them together it looks like the total value given to all the unsecured claims is about 1.5 million and there are over 20 million in claims. There just isn’t any other value to give out. The Woodbrooks court says they have to be classified separately because they have different rights. But the problem with classifying them differently is that it looks like there is unfair discrimination because class 2 gets much more than class 3.


If the plan unfairly discriminates against Class 3, will that prevent the plan from being confirmed? Does the plan unfairly discriminate against Class 3?

If it does unfairly discriminate then it will prevent the plan from. Does it? That is the million dollar question. He thinks it does. If you accept the Dow Corning Markell test then it does unfairly discriminate, if you accept the Pattni 4 prong approach then probably not. 1) Do we have to do this to confirm the plan; 2) Is it reasonable in light of what you need to do; 3) etc. Pattni p. 807.


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