How to Calculate the Distribution Due on a Claim Subordinated to Equity Level?
Section 510(b) of the U.S. Bankruptcy Code specifically provides that certain claims arising from the purchase or sale of common stock of the debtor shall have the same priority as common stock. Since in many bankruptcy cases common equity holders receive no distribution, the question of how to value and treat such subordinated claims is theoretical. But, in the case of Orange County Nursery, common shareholders were entitled to distribution. Hence, the dilemma: the creditors had a fixed monetary claim, not a number of shares; the confirmed plan, however, provided shareholders with pro rata distribution based on their shareholdings. How can the two be reconciled?
Background
Holders of the minority of the debtor’s pre-petition equity, referred to as the Minority Voting Trust (the “Trust”), filed a claim against the debtor. The bankruptcy court valued the claim at approximately US$2.5 million. Following litigation and appeals, the district court held that the Trust held a claim, not an interest, but subordinated the claim to the level of common stock. The confirmed plan in the case provided that common stockholders may retain their interests, or have them cancelled in exchange for a pro rata share of the debtor’s liquidation value as of the confirmation date.
The Trust argued that its claim should be separately classified and paid in cash, or alternatively, that the debtor’s equity be redistributed among the shareholders and the Trust based on the current value of the debtor’s equity and giving effect to the value of the Trust’s claim.
The debtor argued that there is no basis, nor authority for the separate classification and cash payment to the Trust and that the claim should be merely placed in the equity class and that no modifications to the plan were required. Obviously, the debtor’s position did not address the real crux of the issue -- how will the distribution on account of a fixed claim be determined.
The Decision
While the court rejected the Trust’s argument that it should be separately classified and be paid in cash, it largely held in its favor. The court agreed with the Trust that the subordination does not affect the value of its claim, it affects its priority. Thus, the only way to mesh the fixed value of the Trust’s claim with its common stock priority, is to effect some type of ratable redistribution of the debtor’s equity. Recognizing that the debtor’s value decreased since the petition date, it was possible that the effects of such redistribution will turn the Trust from a minority shareholder, to the majority.
Since the parties did not propose a mechanical formula for the court to adopt, the court proposed a formula and allowed the parties to file further briefs addressing the proposal.
As to ratable redistribution, the court proposed that all equity holders, other than the Trust, be valued using the percentage of their holdings multiplied by the value of the debtor’s equity value. That value would then be added to the Trust’s claim, resulting in an aggregate dollar amount for all equity holders. Then, each equity holder will receive percentage equity based on the holder’s percentage of the aggregate dollar amount. For example, if the equity value is US$4 million, the majority’s 50.25% of the equity equates to US$2.01 million; other shareholders’ 9.5% equates to US$380,000 and adding the Trust’s claim (including attorneys’ fees) of approximately US$3.3 million, results in a total dollar value of US$5.7 million. Redistributing the equity based on that formula results in the old majority receiving 35.64% of the equity, other holders receiving 6.64% and the Trust receiving 58.2%.
The remaining complication was the need to determine the debtor’s current equity value. In most cases there is no need to do so in order to distribute that value to equity holders since they all share pro rata, but here, in light of the Trust’s monetary claim, the residual value of the equity was at the core of the court’s proposed formula for the redistribution of the equity. Thus, the court ordered the parties to either agree on the debtor’s current equity value, or propose an expedited way for the court to make the determination.
Implications
In cases where litigation over subordination is pending, parties must be proactive in charting the course for the case. One option is to alert the court to these potential post-confirmation complications, in asking the court for a pre-confirmation expedited determination of the dispute. Another, is to include in the plan the formula and the method to be used in effectuating the distributions to equity holders in the event that the subordination attempt is successful post-confirmation. Or, parties may seek to consummate the plan and stake their arguments on equitable mootness. Whatever is the chosen approach, better be prepared than surprised.
