Chapter 11 Working Group Proposal #14: Elimination of Prohibition on Nonvoting Equity Securities

In its list of mandatory contents of a plan of reorganization, section 1126(a) of the Bankruptcy Code requires that the reorganized debtor’s charter contain a provision that prohibits the debtor from issuing nonvoting stock. [ FN: 11 U.S.C. §1123(a): "Notwithstanding any otherwise applicable nonbankruptcy law, a plan shall - . . . (6) provide for the inclusion in the charter of the debtor, if the debtor is a corporation, or of any corporation referred to in paragraph (5)(B) or (5)(C) of this subsection, of a provision prohibiting the issuance of nonvoting equity securities, and providing, as to the several classes of securities possessing voting power, an appropriate distribution of such power among such classes, including, in the case of any class of equity securities having a preference over another class of equity securities with respect to dividends, adequate provisions for the election of directors representing such preferred class in the event of default in the payment of such dividends. "] This provision has been the subject of criticism and appears to serve no useful function in the present system.

The Recommendation

Congress should amend section 1123(a)(6) to eliminate the requirement that the charter of the reorganized corporate debtor prohibit the issuance of nonvoting equity securities. Section 1123(a)(6) should otherwise remain unchanged.

Reasons For The Change

Section 1123(a)(6) had its roots in a similar provision in the Bankruptcy Act of 1898. [ FN: In re Acequia Inc., 787 F.2d 1352 (9th Cir. 1986) (noting that section 1123(a)(6) was derived from 11 U.S.C. §616 of Bankruptcy Act of 1898 and copied almost verbatim), citing S.Rep. No. 95 - 989, 95th Cong., 2d Sess. 119, reprinted in 1978 U.S. Code Cong. & Ad.News 5787, 5905 (indicating interest in ensuring that investors were able to maintain voice in selection of management of reorganized firm).] In the 1930s, Congress and the Securities and Exchange Commission feared that insiders retained too much control over reorganization to the exclusion of public stockholders. [ FN: See 7 Collier on Bankruptcy ¶ 1123.01[f][6] (1996); S.E.C. Report on the Study and Investigation of the Work, Activities, Personnel and Functions of Protective Committees, Part I, 903 (1937), Part VIII 156 (1940).] The prohibition on nonvoting stock was intended to promote the fair distribution of voting power to elect managers of a reorganized debtor. While this provision may have served that function in the 1930s, the multiplicity of corporate structures used today, along with the active participation of classes of creditors negotiating for equity participation, leave the provision with little relevance in the modern corporate world. [ FN: Accord, Ginsberg & Martin on Bankruptcy, §13.09[H] (Supp. 1997) ( "These provisions, which are a carryover from old chapter X and represent the thinking of the Securities and Exchange Commission in the 1930s about how large publicly held corporate debtors are reorganized, are archaic ").] The inclusion of this provision in the Bankruptcy Code has been thesubject of much question, [ FN: See, e.g., Letter of May 8, 1997 to Brady Williamson from L.E. Creel, III (deeming the provision ’s inclusion to be a "glitch "); 7 Collier on Bankruptcy ¶ 1123.01[f][6] (1996) ( "It is suggested that the inclusion of section 1123(a)(6) was not well considered and represents an intrusion of the paternalistic hand of chapter X into practice under chapter 11 of the Bankruptcy Code "); Kenneth N. Klee, "Adjusting chapter 11: Fine Tuning the Plan Process, " 69 Am Bankr. L. J. 551, 555 (1995) (noting that this "anomalous " provision was retained as political concession).] and there seems to be little evidence that this prohibition has been beneficial. First, it is easily circumvented; for example, a debtor might create a voting trust or issue preferred stock with limited voting rights and still be in compliance with the law. [ FN: See Richard L. Epling, "Fun with Nonvoting Stock, " 10 Bankr. Dev. J. 17, 20 (1993/1994) (noting existence of case law permitting creation of restrictive voting trusts in connection with plan, and describing other methods that comply with the section 1123(a)(6) restrictions but potentially disenfranchise common shareholders); The National Bankruptcy Conference, Reforming the Bankruptcy Code: The National Bankruptcy Conference ’s Code Review Project 290 (1994); Kenneth N. Klee, "Adjusting chapter 11: Fine Tuning the Plan Process, " 69 Am Bankr. L. J. 551, 555 (1995) (noting confusion over whether securities with only limited voting rights satisfy the section 1123(a)(6) requirement).] Second, chapter 11 specifically provides tools that deal with the earlier concerns of Congress and the S.E.C. For example, the remainder of section 1123(a)(6) and 1123(a)(7) [ FN: 11 U.S.C. §1123(a)(7) provides that a plan shall "contain only provision that are consistent with the interests of creditors and equity securities holders and with public policy with respect to the manner of selection of any officer, director, or trustee under the plan and any successor to such officer, director, or trustee. "] more effectively address the concern of excessive insider control over management, as do the Code’s disclosure and confirmation requirements, which provide parties with more direct means to prevent disenfranchisement. Some commentators also have noted that a literal reading of the charter provision requirement is especially problematic when the debtor is being acquired by a pre-existing corporation that was not organized for the purpose of making this acquisition. [ FN: See Ginsberg & Martin on Bankruptcy, §13.01[H] at 13-61 (Supp. 1997).]

There also may be valid reasons to make nonvoting stock available to parties in interest. This is an issue that arises in large cases, where all parties will be benefitted by the availability of a full panoply of corporate ownership tools, and becomes particularly crucial when the debtor proposes to issue new stock to the unsecured creditors in full or partial satisfaction of their claims. [ FN: See Richard L. Epling, "Fun with Nonvoting Stock, " 10 Bankr. Dev. J. 17 (1993/1994).] Some creditors, such as banks, are not permitted to hold voting securities. [ FN: 12 U.S.C. §1843.] The workout process also would be facilitated if there were greater flexibility in dealing with a debtor’s securities. [ FN: Letter of May 8, 1997 to Brady Williamson from L.E. Creel, III. See also Epling, at 21 (noting that primary issue should be whether creditor class votes to accept nonvoting stock).]

Competing Consideration

Some parties might believe that Congress’ concerns in the 1930s regarding insider control may hold true today and warrant protections against disenfranchisement. Even if one thinks that this is the case, however, other requirements of chapter 11 are more responsive to this concern than this provision in section 1123(a)(6), which seems to be an easily-circumvented and ineffective solution to the alleged insider control problem.