19 May Section 1145: Creating Shells & Equity Holders from Bankrupt Public Companies
Distressed public companies present an interesting opportunity for the savvy securities attorney. The right bankrupt, public shell can often be utilized in the creation of several more vehicles, all with their own base of shareholders, with a completely clean slate. As part of Section 1145(a)(1) of the United States Bankruptcy Code, a public debtor emerging from bankruptcy can offer new securities without the need of a full S-1 registration with the SEC. Such new securities could include common stock, preferred stock, warrants or rights. As one might imagine, this presents an interesting opportunity for creating public shells out of what some have called “thin air.” In most cases, a distressed company does not have the time or monetary resources to get involved in a complete fresh registration like this. That’s where Section 1145 comes in. A company can now more easily and affordably reorganize itself (including converting some debt into equity or warrants) and create more value with a new public entity with the issuance of pristine, newly-minted securities without ever having to register. Here are some specifics on when a debtor can issue unregistered securities:
(1) the offer or sale under a plan of a security of the debtor [is]…
(A) in exchange for a claim against…the debtor
or (B) principally in such exchange and partly for cash or property
Whatever the prior claims against the bankrupt debtor company are completely irrelevant. That means debt, preferred stock, or unsecured other obligations are irrelevant to the new, public issuance. The only stipulation in the new offering and the conversion from another security is that the new security must be sold in exchange for some claim and some cash (typically a very small amount). If not, the exchange would be considered a sale of securities and thus subject to registration requirements.
The goal is to properly balance the reorganization of debt under the Bankruptcy Code while at the same time avoid the prohibition issues inherent with marketable securities and thereby avoid a full SEC registration statement. If a company were confined to typical registration requirements, then they would have to incur the expense of securities registration. This method allows for post-bankruptcy financing in that it allows for the issuance of securities without the need for a typical registered offering. In addition, by having access to the more liquid public markets, the drafters of this particular legislation rightly knew the ability for creditors to recoup some of their losses without completely losing the basis once held in the original securities of the bankrupt firm in question.
To avoid the potentiality of the use of this type of unique structure simply as a creation tool for unregistered securities, the law has been interpreted such that a typical exchange of this type requires an legit transaction wherein the value of the securities issued exceeds the value of the creditors’ claim on the assets of the company.
Typically, Chapter 11 bankruptcies of mortgage or other secured assets against default make for some of the best opportunities to exercise Section 1145. This process can be a very valuable mechanism to the debtor whose business meets the cash-flow requirements of a good Chapter 11 process.
Crafting publicly-held securities this way, presents an interesting opportunity for companies looking to go public via some type of alternative path. It not only makes things cheaper for the eventual reverse takeover facilitator, but it also means (if controlled from the outset) that the vehicle you use, can and will have all the desired structure of the intended issuer. That’s because the pubco is created from scratch through this process.