Contributed by Conray C. Tseng
This Throwback Thursday, we are going old school to 1986 to answer the question – does section 1123(a)(6) of the Bankruptcy Code prohibit a debtor from retaining existing nonvoting equity securities? Further, can a debtor modify existing voting equity securities and render them nonvoting? Yes and no, according to the Ninth Circuit in In re Acequia, Inc..
Before we hop into the time machine (and the case law), let’s review section 1123(a)(6) and other provisions of the Bankruptcy Code governing corporate governance. Section 1123(a)(6) of the Bankruptcy Code provides that “notwithstanding any otherwise applicable nonbankruptcy law, a plan shall provide for the inclusion in the charter of a debtor, if the debtor is a corporation … a provision prohibiting the issuance of nonvoting equity securities.” Section 1123(a)(6) also requires that a plan allocate “an appropriate distribution of [voting] power” among “the several classes of securities possessing voting power.” Further, complementing section 1123(a)(6) is section 1123(a)(7)’s requirement that a plan “contain only provisions that are consistent with the interests of … equity security holders and with public policy with respect to the manner of selection of any officer, director, or trustee….” With the statutory language as our guide post, let’s go back to the 1980’s.
Acequia was a family owned land management corporation based in Idaho. In 1981, the company’s equity owners, Vernon B. Clinton and Rosemary Haley, divorced and divided Acequia’s shares 50-50. In 1982, Acequia commenced a voluntary chapter 11 case. At the time, Mr. Clinton controlled Acequia’s day-to-day operations. Mr. Clinton and Ms. Haley’s relationship, however, had precipitously degraded since their divorce, and Ms. Haley alleged that Mr. Clinton had mismanaged Acequia and willfully failed to disclose pertinent information in Acequia’s schedules and statement of financial affairs.
Because of Mr. Clinton’s misconduct, Ms. Haley and Acequia’s secured lenders sought the appointment of a chapter 11 trustee. At the hearing to consider the appointment of a trustee, Ms. Haley submitted evidence that Mr. Clinton failed to disclose $1.6 million in personal cash withdrawals from Acequia and failed to identify assets in excess of $1 million. An independent auditor characterized Mr. Clinton’s nondisclosures as “grossly misleading” and “fraudulent.”
Prior to the bankruptcy court’s ruling on the trustee motion, Mr. Clinton, Ms. Haley and Acequia’s secured lenders agreed to settle the matter in exchange for an irrevocable proxy, executed by Mr. Clinton, permitting Ms. Haley to vote Mr. Clinton’s stock and manage Acequia for 30 months.
In 1983, Acequia proposed a chapter 11 plan that would pay all creditors in full by 1992 through rental payments and certain asset sales. The plan also provided that Ms. Haley and her two sons would become directors of reorganized Acequia and that all existing equity holders would be divested of their right to elect and replace directors. Instead, if a director could no longer serve, the remaining directors would select the successor.
Mr. Clinton objected to the plan because, among other things, section 1123(a)(6) of the Bankruptcy Code requires that a debtor’s charter be modified to prohibit the issuance of nonvoting equity securities. The bankruptcy court overruled Mr. Clinton’s objections and confirmed the plan. Mr. Clinton’s objections eventually made their way to the Ninth Circuit.
The Ninth Circuit affirmed the bankruptcy court’s decision, holding that section 1123(a)(6) of the Bankruptcy Code only prohibits the issuance of new nonvoting equity securities. The Ninth Circuit also looked to section 1123(a)(6)’s requirement of an “appropriate distribution of [voting] power” as to the “several classes of securities possessing voting power” and section 1123(a)(7)’s requirement that plan provisions be “consistent with the interests of … equity security holders and with public policy with respect to the selection of any officer, director, or trustee.” The Ninth Circuit held that the two provisions, read together, required the court to scrutinize any plan that alters voting rights or establishes management.
The Ninth Circuit held that Mr. Clinton’s failure to disclose material information alone did not warrant denying him voting rights and cautioned that that “a shareholder’s participation in a corporation cannot be lightly cast aside.” Nonetheless, because of Mr. Clinton’s previous mismanagement as well as the bankruptcy court’s finding that joint management would result in “deadlock, chaos, [and] continued problems with the execution of the plan” and threaten the debtor’s reorganization, the Ninth Circuit concluded that “special circumstances” existed and affirmed the bankruptcy court’s approval of the proposed modifications of the shareholders’ voting rights.
In the 27 years since Acequia, various lower courts have continued to follow the principles set forth by the Ninth Circuit, including the U.S. Bankruptcy Court for the Southern District of New York in In re Texaco Inc., 81 B.R. 806 (Bankr. S.D.N.Y. 1988). This issue, however, has not been seriously contested since. Perhaps it is a reflection that this is now settled case law (or perhaps there are too few solvent debtors for the issue to arise).