Fair Funds for Investors: Comparing WorldCom and Kmart
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Two titanic Chapter 11 shipwrecks – WorldCom and Kmart – have had quite disparate results for investors. How did the shareholders fare in these two Chapter 11 bankruptcies?
WORLDCOM
On July 7, 2003, United States District Judge Jed Rakoff, of the Southern District of New York, approved a settlement between the SEC and WorldCom to make WorldCom pay a record-breaking $750,000,000 to investors who allege they lost $200,000,000,000 as a consequence of WorldCom’s accounting shenanigans. In approving the settlement, Judge Rakoff issued a groundbreaking opinion. See SEC v WorldCom (SD NY, July. 7, 2003, No. 4693) available at the Southern District’s website. <http://www.nysd.uscourts.gov/rulings/02cv4963_070703.pdf>
The investors are the common shareholders of WorldCom. WorldCom is in Chapter 11 bankruptcy and balance-sheet insolvent. The absolute-priority rule is a fundamental of United States bankruptcy law. See 11 USC §1129; Norwest Bank Worthington v Ahlers, (1998) 485 US 197, 108 S Ct 963, 99 LEd 2d 169; Case v Los Angeles Lumber Products Co., Ltd., (1939) 308 US 106, 60 S Ct 1, 84 LEd 110.
The Absolute Priority Rule
Under the absolute priority rule, a senior class of creditors must receive full payment before a junior class may receive anything at all. In addition, no class of equity securities (such as common shareholders) may receive any payment until all creditors and senior equity security holders, if any, have been paid in full. The shareholders of a corporation that is balance-sheet insolvent are supposed to receive nothing at all.
There have been limited ways that shareholders may circumvent the absolute priority rule. See Thomas Henry Coleman and David E. Woodruff, Looking Out for Shareholders: The Role of the Equity Committee in Chapter 11 Reorganization Cases of Large, Publicly Held Companies, 68 American Bankruptcy Law Journal 295 (Summer 1994). Generally speaking, such circumvention of the bankruptcy laws has been difficult. Moreover, Section 510(b) of the Bankruptcy Code explicitly subordinates the rescission or damages claims of defrauded shareholders, rendering such claims otiose.
"Fair Funds for Investors"
In 2002, along came Section 308(a) of the Sarbanes-Oxley Act, entitled "Fair Funds for Investors," that has enabled the SEC to add civil penalties to disgorgement funds for the relief of the victims of stock swindles. Under Section 308(a), the SEC has negotiated a large – nay, a VERY large – penalty with the Debtor-in-Possession management of WorldCom, totaling $2,250,000,000, with $750,000,000 of the penalty allocated for distribution to the pre-bankruptcy shareholders of WorldCom. Of the latter sum, $500,000,000 will be distributed in cash, plus $250,000,000 worth of new common stock. This distribution is about 75 times the amount of the next largest civil penalty distribution to shareholders.
The Debtor-in-Possession must fund this civil penalty, and as a result $750,000,000 in value will be leaving the bankrupt WorldCom and paid via the SEC to the old WorldCom shareholders. The SEC, as the recipient of the civil penalty, could utilize the $2,250,000,000 in any constitutional way it sees fit. A donation to victims of frauds of every kind; a donation to educate the masses on virtue; a donation to flood victims; or a minuscule reduction of the National Debt.
By the same token, any creditor in a bankruptcy case may decide to donate the distributions resulting from its allowed claim to anyone, including the members of a junior class in the same bankruptcy case. So, for example, a secured creditor in a bankruptcy case may lawfully donate the proceeds of its claim in a specified amount to the unsecured creditors, or to the equity security holders.
Does this transfer of wealth violate the absolute priority rule? Of course not, because it is the joint, voluntary act of the Debtor-in-Possession, and a senior claimant, the SEC. In the WorldCom situation, there was no circumvention of the absolute priority rule, because the Debtor-in-Possession management entered into a monetary compromise settlement of a controversy, approved by the Official Unsecured Creditors’ Committee.
KMART
Like WorldCom, Kmart wound up in Chapter 11. Like WorldCom, Kmart went into Chapter 11 balance-sheet insolvent. But unlike WorldCom’s shareholders, and despite the presence of an equity security holders committee that was supposed to represent Kmart shareholders, the pre-bankruptcy Kmart shareholders got nothing under Kmart’s plan of reorganization, recently confirmed by the Bankruptcy Court.
Outraged Kmart shareholders, including thousands of former employees, are looking for justice, and they believe the law and the system have mistreated them. The problem for Kmart shareholders is that the bankruptcy laws were administered as required, and the shareholders therefore received nothing.
But what of the SEC? What of Section 308 of Sarbanes-Oxley and "Fair Funds for Investors?" To be sure, the SEC, the FBI, the US Attorney’s Office and the US Congress House of Representatives Energy and Commerce Committee have all devoted considerable study to Kmart’s slide into insolvency and ruin. However, the key to "Fair Funds for Investors" is a civil penalty from the SEC. After spending more than a year reviewing Kmart’s books, the SEC recently decided that it would not seek a civil penalty or seek to obtain disgorgement of ill-gotten gains.
Conclusion
Substantive legal rights and remedies are supposed to be protected through the initiative of the injured and their lawyers. Now, however, a new element, beyond any practical victim control, has emerged, viz., the SEC as selective champion of shareholders’ monetary recoveries. The implications are, ironically, that shareholders of public companies whose financial machinations amount to gross, clear-cut, easily provable frauds, may well wind up as well-heeled beneficiaries of the SEC’s largesse. At the same time, shareholders of public companies guilty only of minor financial peccadillos, combined with a lot of gross mismanagement and terrible business judgment, are totally wiped out and uncompensated. For those inclined to search for an explanation, please read Finley Peter Dunne, Mr. Dooley.
Thomas Henry Coleman, Partner, Troy and Gould Professional Corporation, Los Angeles. Mr. Coleman is a contributing author to Advising and Defending Corporate Directors and Officers published by CEB. The firm’s website address is <http://www.troygould.com> and Mr. Coleman can be reached by e-mail at <thcoleman@troygould.com> |
