Chapter 11 reorganization is primarily known as a tool to reorganize debts. Although individuals may opt to reorganize their debts through Chapter 11 under certain circumstances, Chapter 11 is more typically used to reorganize business debts. For a business, Chapter 11 is most often used to restructure debts and slow creditor actions. However, Chapter 11 has less apparent uses, one of which is to disengage a deadweight or silent business partner or equity owners from your business.
For a plan of reorganization to be approved by the court, numerous requirements must be satisfied. With regard to ownership, if the shareholders’ rights are modified in any way through the Chapter 11 process, the shareholders as a separate voting class must accept the plan of reorganization with votes of at least two-thirds of the total amount of equity interests. If they do not, the plan will not be approved. If the Chapter 11 plan does not modify the shareholders’ rights, then they do not need to vote on the plan, and it will be approved as long as the plan complies with other Bankruptcy Code requirements.
Ousting unwanted shareholders cannot happen simply by the plan providing for their interests to terminate while a dominating shareholder retains his interest. This would violate the Bankruptcy Code requirement that each member of a class of creditors or equity owners receive equal treatment. But if the plan is structured properly, you can still achieve that result.
By way of illustration, assume a company called XYZ Fitness has five shareholders: one equity owner (the majority owner) who holds 70 percent of the total equity interests, and the remaining four equity owners (the minority owners) who hold the remaining 30 percent. The majority owner was active in the operation of XYZ Fitness prior to and during the bankruptcy case and wants full control of the company once it reorganizes its affairs. The minority owners, on the other hand, were not active in the company’s operations prior to or during the bankruptcy case. The majority owner believes the minority owners are deadweight and of no value to the business.
Under the majority owner’s ideal scenario, the minority owners will no longer own any of XYZ Fitness’ equity, but because the minority owners’ rights are being modified, this plan requires a vote by the equity class. In this example, the majority owner holds 70 percent of the equity, more than the requisite two-thirds of all equity interests needed for approval. Thus, the majority owner’s vote in favor of this arrangement satisfies the two-thirds of total equity voting requirement for approval. On the other hand, minority owners who want to oust a majority owner (even one that holds less than two-thirds of all equity interests) are unlikely to be able to do so because majority owners usually control the corporate governance of the company and would not authorize a proposed plan that would wipe them out of ownership or the operations.
In addition to requiring a vote, any plan that modifies the shareholders’ rights must provide equal treatment, or give the same options, to all of the equity owners. For example, the plan can set certain conditions for an individual to become an owner of the reorganized business, such as infusion of new capital into the business, execution of personal guarantees of corporate obligations and/or entry into an employment agreement with the reorganized business. These conditions require new owners to reinvest capital, personal credit and time into the reorganized business. Minority or silent owners who already lost their initial investment in the company and likely have another career often will be unwilling to become an owner of the reorganized business under these conditions. As long as the plan provides the same options to all owners, however, the requirement of “equal treatment” is satisfied and the plan can be approved.
Returning to our example, if the majority owner infuses capital into the new company, executes personal guarantees of the corporate obligations and signs an employment agreement, he or she likely will be the only equity member that does so, making him or her the 100 percent owner of the reorganized business. The result is that the company is healthier when it emerges from Chapter 11, and the owner has ousted unwanted business partners in the process.
Jessica Grossarth is a partner in the bankruptcy practice at Pullman & Comley LLC. She is a former Division I basketball player and a current fitness fanatic.