ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF PENNSYLVANIA (D.C. No. B-70-347 In Bankruptcy)
Before Aldisert, Gibbons and Higginbotham, Circuit Judges.
We deal in this opinion with appeals by two indenture trustees, representing four secured bond issues, from orders of the district court approving and confirming the Amended Plan of Reorganization of Penn Central Transportation Company (PCTC or the Debtor) and related debtors in reorganization under § 77 of the Bankruptcy Act, 11 U.S.C. § 205.*fn1 Judge Aldisert's opinion in In re Penn Central Transportation Co. (Reorganization Plan Appeals), 596 F.2d 1127, Nos. 78-1698/1700, 78-1702/03, 78-1710, 78-2311/12, 78-2314/15 and 78-2319/20 (3d Cir. January 11, 1979), filed simultaneously herewith, rejects challenges by other secured creditors to the Plan of Reorganization. Reference is made to that opinion for an account of the history of the proceedings, and a description of the debtor estates, the structure of the Plan, and the legal justifications for that structure. Judge Higginbotham's opinion in In re Penn Central Transportation Co., 596 F.2d 1155 (Stockholder Appeals ), Nos. 78-1715, 78-2321, and 78-2336 (3d Cir. January 11, 1979) rejects challenges to the Plan made on behalf of shareholders in the Penn Central Company, the Debtor's sole stockholder.
This opinion considers specific objections to the treatment of certain secured creditors.*fn1a The Irving Trust Company is indenture trustee under a Collateral Trust Indenture dated April 15, 1965, made by New York Central Railroad Company (a predecessor of the Debtor) securing a claim of $7,800,000 principal amount of New York Central 6% Bonds due April 15, 1990 (the New York Central 6's). It is also trustee under a Collateral Trust Indenture dated April 15, 1968, made by Penn Central Company (a predecessor of the Debtor) securing a claim of.$7,641,800 principal amount of Penn Central 61/2% Bonds due April 15, 1993 (the Penn Central 61/2's). Finally, Irving Trust is successor indenture trustee under a First Mortgage dated July 1, 1892, made by The Mohawk and Malone Railway Company (a predecessor of the Debtor), which secures a claim of $1,489,000 principal amount of 4% Gold Bonds due September 1, 1991 (the Mohawk & Malone Bonds). Interest arrearages on the Mohawk & Malone Bonds total $478,000 as of December 31, 1977. The Bank of New York is successor indenture trustee under The New York Central and Hudson River Railroad Company Refunding and Improvement Mortgage of October 1, 1913 (the R & I Mortgage). That mortgage secures a claim of $214,470,000, representing $125,351,000 41/2% Series A Bonds and $89,119,000 5% Series C Bonds held by the public. Appellant Harriet Signer is a holder of R & I Bonds.
The indenture trustees representing these creditors do not object to the basic structure of the Plan of Reorganization, but only to the allocation of securities to them within that structure. The three Irving Trust issues all of which were accorded "super secured" status in the final Plan contend that the distributions proposed to be made to them under the Plan do not provide them with compensation that is the equitable equivalent of the well-secured claims that they will be required to surrender. Therefore, they contend, the Plan violates the rule of absolute priority, originally applied in diversity railroad equity receiverships, Northern Pacific Ry. v. Boyd, 228 U.S. 482, 33 S. Ct. 554, 57 L. Ed. 931 (1913), and subsequently in proceedings under § 77 as well. E. g., Group of Institutional Investors v. Chicago, M., St. P. & Pac. R.R., 318 U.S. 523, 63 S. Ct. 727, 87 L. Ed. 959 (1943). The R & I bondholders' more modest assertion is that the proposed distribution to them is insufficient because of the Plan's failure to treat certain assets of the estate as properly subject to the lien of the R & I Mortgage. We will deal with these distinct contentions separately under the captions "I. The Irving Trust Appeals" and "II. The R & I Appeal." Our resolution of these issues, which requires some modification of the distributions to these appellants, does not affect the confirmation or consummation of the Plan.
I. THE IRVING TRUST APPEALS
1. The Claims and Their Underlying Security
The claims of the two Collateral Trust Bond issues,*fn2 although they differ slightly in their details, are essentially similar. The New York Central 6's have a claim of $7,800,000 principal amount. As of December 31, 1977, accrued unpaid interest on the bonds amounted to $332,000. That claim is secured by 78,000 shares of the capital stock of the Pittsburgh & Lake Erie Railroad Co. (P&LE) pledged under the Trust Indenture. The P&LE is an independent, profitable railroad, 92.61% Of whose stock is held by the Debtor. None of the Debtor's P&LE stock was conveyed to ConRail pursuant to the Regional Rail Reorganization Act (RRRA). The Trustees treated the P&LE stock, for purposes of the Plan, as having a value of $100.15 per share, and the reorganization court, by confirming the Plan, implicitly approved that valuation.*fn2a While there was conflicting evidence as to the value of the stock, we think that the Trustees' proposed valuation, approved by the reorganization court, is not clearly erroneous, and we adopt it here. In addition, the 6's are secured by $3,900,000 principal amount of R & I 5% Series C Bonds. In the Plan, these bonds are treated as secured by retained assets to the extent of 35.9% Of their face amount. Based on these figures, the value of the retained asset security underlying the claim of the New York Central 6's is $9,211,800. Their ratio of retained asset security to secured debt is thus 113.28%.
The Penn Central 61/2's have a claim of.$7,641,800 principal amount, and accrued interest as of December 31, 1977, of $353,000. The claim is secured by 83,698 shares of P&LE stock, and $4,185,000 principal amount of R & I 5% Series C Bonds. The value assigned this security under the Plan was $9,884,770, and the ratio of retained asset security to the total claim is 123.64%.
The Mohawk & Malone claim, including interest, totals $1,967,000. It was originally secured by all of the railroad's assets. In July, 1972, the Interstate Commerce Commission approved a petition by the Trustees to abandon the railroad's Lake Placid branch. In February, 1975, the State of New York condemned the abandoned line. Pending a final judicial determination of the condemnation award, the State of New York has paid over to the estate the sum of $3,900,000, representing its offering price less certain expenses. That sum, along with proceeds of sale of other encumbered assets, has been deposited in an escrow account which now totals $4,535,000. In addition the bonds are secured by other retained assets worth $850,000. Thus the total security for $1,967,000 is a first lien on $5,385,000 in assets. On the basis of escrowed cash alone this mortgage indenture is 230.55% Secured. Counting other retained assets it is 273.77% Secured.
2. The Proposed Distributions Under the Plan
As Judge Aldisert explains in greater detail in his opinion, the foundation of the Plan's distribution to secured creditors is the assumption that at the conclusion of the Valuation Case the estate of the Debtor will prove to be solvent. The Plan therefore treats each secured creditor as fully secured, regardless of the degree to which that creditor is secured by conveyed assets whose ultimate value to the estate is as yet undetermined. For every $100.00 of claim, each secured creditor receives a payment package consisting of 10% In cash, payable upon consummation, 30% In General Mortgage Bonds, 30% In Redeemable Preference Stock, and 30% Common Stock of the Reorganized Company.
Within this package, the Plan originally recognized the relatively stronger position of creditors fully or partially secured by retained assets through its formula for the distribution of General Mortgage Bonds. The Bonds were divided into Series A and B. Within the 30% Of the total distribution represented by the mortgage bonds, each secured creditor was awarded Series A Bonds in proportion to the degree that his claim was secured by retained assets of the Debtor. The remainder of the 30% Was satisfied with Series B Bonds. Thus, for example, a claim 70% Secured by retained assets would receive, for each $100.00 of claim, $21.00 in Series A Bonds and.$9.00 in Series B Bonds. Beginning in 1981, both series of bonds will bear interest at an annual rate of 7%. Series A Bonds are to be redeemed out of the proceeds of the sale of the Debtor's marketable retained assets, upon which the Plan gives them a claim ahead of the claim of the Series B Bonds. The Trustees' cash flow predictions indicate that the proceeds from the sale of these retained assets should be sufficient to retire all outstanding Series A Bonds and 11.25% Of the Series B Bonds by 1983, and to pay most of the interest on the Series B Bonds through 1987. The bulk of the Series B Bonds will, however, probably be redeemed principally out of the proceeds of the Valuation Case, in which their claim comes behind an estimated $1.278 billion of government and state and local tax claims. Series B Bonds not redeemed in the Valuation Case convert into Common Stock of the Reorganized Company. Series A Bonds come behind Series B Bonds in the Valuation Case. Series A Bonds that survive any shortfall in both the distribution from retained assets and the Valuation Case will remain as general obligations of the Reorganized Company.
Preference stock was originally proposed as a single issue to all secured creditors alike at a rate of 1.5 shares for every $30.00 of claim surrendered. Beginning in 1982, preference stock is redeemable out of the earnings of the Reorganized Company at a price of $20.00 per share, provided that the Reorganized Company's consolidated net income exceeds $50,000,000 and sufficient cash is available to cover the redemption. Up to 5% Of the total preference stock allocation may be retired each year in this fashion. If the income test is met, but no cash is available, the obligation to redeem will cumulate from year to year. The Trustees' figures show that the income test for redemption will be met in 1981, but there are no income or cash availability figures which would permit an educated estimate of the likelihood that preference stock will be redeemed from earnings in 1981 or in later years. Preference stock is also redeemable from the Valuation Case proceeds, with a claim subordinate to those of the federal government, the state and local taxing authorities, and the Series B and A Mortgage Bonds. Each share of preference stock has 2/3 of a vote in the shareholders' councils of the Reorganized Company. Any preference stock unredeemed at the end of the Valuation Case will convert to Common Stock in the Reorganized Company at the rate of one share of Common for every 6.5 shares of Preference Stock. Holders of preference stock also may, at their option, convert to common stock at the same ratio at any time prior to the close of the Valuation Case.
The Common Stock, which represents the last 30% Of face amount of each secured creditor's claim, remains entirely at the risk of the reorganized enterprise. Its present value is low. Its future value depends largely upon the fulfillment of two uncertain hopes: first, that the Valuation Case recovery will be sufficient to satisfy the massive prior claims of secured and unsecured*fn3 creditors and to produce an additional large bonus for the equity; and second, that the Reorganized Company, its assets heavily encumbered with past claims, will earn enough to retire its senior debt securities and produce a substantial equity for stockholders.
In the version of the Plan originally presented to the reorganization court, no provision was made for any classification of secured creditors other than that afforded by the division of General Mortgage Bonds into Series A and B. Before that court, however, a number of representatives of secured creditors, including Irving Trust, protested the proposed Plan's allocation of securities as violative of the absolute priority rule. Their contention was that since the Plan purported to be a fair and equitable compromise of the disputes that would have arisen in a litigated liquidation of retained assets, the allocation of compensation under the Plan should provide recognition of the stronger position of those mortgage bonds which, by virtue of the depth or position of their security, could demonstrate that they were likely to be paid off in full at the close of such a liquidation.
The reorganization court recognized the force of this argument. Applying the standards for the evaluation of compromises announced in Protective Committee for Independent Stockholders of TMT Trailer Ferry Association v. Anderson, 390 U.S. 414, 88 S. Ct. 1157, 20 L. Ed. 2d 1 (1968), it concluded that no secured creditor was assured of surviving a litigated liquidation. It also concluded, however, that a handful of bondholders were significantly more secured by retained assets than others, were considerably more likely to emerge from a litigated liquidation with payment of all or nearly all of their claim in cash, and therefore merited more consideration than the Plan provided them. Referring to that group of creditors as "super secured," it wrote:
The foregoing discussion leads to the conclusion that, generally speaking, the "super secured" creditors as a group receive appropriate allocations of retained assets for purposes of the A-B bond distributions under the Plan. All have retained asset coverage in excess of 100% Of the amounts of their claims, and the Plan accords the same treatment to all of these creditors. But while all of these creditors are on an equal footing, there is some merit in the suggestion that, in the vernacular, some are more equal than others. The Mohawk & Malone (011) mortgage has 275% Retained asset coverage, and the Gold Bond Mortgage has 243% Retained asset coverage. The New York Central 6% Bonds of 1990 and the Penn Central 61/2% Bonds of 1993 have retained asset coverage of approximately 119% And 131% Respectively, and they have the further advantage of the pledge of the Pittsburgh & Lake Erie stock. In my judgment it would be preferable to accord claimants under these four mortgages somewhat better treatment than the Plan provides, if that can be accomplished within the contours of the present Plan.
For the reasons discussed above, I am satisfied that no "super secured" claimant can properly lay claim to more cash or A bonds than the Plan provides. The alternative distribution scheme is invalid, and would not work. But within the framework of the present Plan, there is some room for flexibility in the handling of preference stock. Under the Plan, the selection of preference stock to be redeemed first is to be made by lot. While this is eminently fair as among holders similarly situated, it could, in actual operation, allow holders less favorably situated than the bondholders of these four mortgages to receive satisfaction of their claims before these more favorably situated bondholders. To prevent such an eventuality, in my judgment the solution is simply to include provisions guaranteeing that the holders of preference stock issued in exchange for the surrender of claims under the four mortgages listed above will have rights of redemption Pari passu which take precedence over the redemption rights of other preference shares.
In re Penn Central Transportation Co., 458 F. Supp. 1234, 1302 (E.D.Pa.1978).
The consequence of this decision was an amendment of the preference stock redemption features of the Plan. Two series of preferred stock were created, with Series A Preference Stock distributed to the four "super secured" creditors and Series B to all remaining creditors. As between the two Series, A Preference Stock has a first claim on both the income of the Reorganized Company and the proceeds of the Valuation Case. Since some redemption of some preference stock from the company's earnings is not unlikely, and since the relatively small amount of A Preference Stock ($34,337,000) will come ahead of all B Preference Stock ($523,715,000) in the Valuation Case, the value of the redemption preference afforded by classification in Series A is substantial. The three groups of bondholders represented by Irving Trust Company on this appeal were all designated as recipients of Series A Preference Stock. Thus, under the Plan, the three Irving bond issues each received a 10% Cash distribution, 30% Series A Bonds, 30% Series A Preference Stock, and 30% Common Stock.
1. The Issue and the Standard of Review
In a railroad reorganization the process of allocating the value of the debtor's estate to creditors is regulated by the so-called absolute priority rule. Group of Institutional Investors v. Chicago, M., St. P. & Pac. R.R., 318 U.S. 523, 546, 63 S. Ct. 727, 87 L. Ed. 959 (1943) (Institutional Investors ). The requirements of that rule have been precisely stated in 6A Collier on Bankruptcy P 11.06, at 210-11 (14th ed. 1977):
Under the absolute priority rule, a plan is not "fair and equitable" unless it provides participation for claims and interests in complete recognition of their strict priorities, and unless the value of the debtor's assets supports the extent of the participation afforded each class of claims or interests included in the plan. Any arrangement by which a junior class receives values allocable to a senior class "comes within judicial denunciation." Beginning with the topmost class of claims against the debtor, each class in descending rank must receive full and complete compensation for the rights surrendered before the next class below may properly participate.
(footnotes omitted). The application of this rule to proceedings under § 77 of the Bankruptcy Act is widely recognized*fn4 and is not contested here.
The function of the absolute priority rule is two-fold. First, the rule is intended to assure that the investment securities distributed as compensation under the Plan have a value at least roughly equivalent to the value of the claim surrendered. The reviewing court is therefore required to make "a comparison of the new securities allotted to (the claimant) with the old securities which he exchanges to determine whether the new are the equitable equivalent of the old." Institutional Investors, supra, 318 U.S. at 566, 63 S. Ct. at 749. In addition, the rule commands that until senior creditors have received that "full compensatory treatment," Consolidated Rock Products Co. v. DuBois, 312 U.S. 510, 529, 61 S. Ct. 675, 85 L. Ed. 982 (1941), participation in the estate by junior creditors must be barred. RFC v. Denver & R.G.W.R.R., 328 U.S. 495, 517, 66 S. Ct. 1282, 90 L. Ed. 1400 (1946); In re Central Railroad Co. of New Jersey, 579 F.2d 804, 810 (3d Cir. 1978). These standards of priority protect both the principal of and interest on the senior creditor's claim. Institutional Investors, supra, 318 U.S. at 546, 63 S. Ct. 727. They also shield a secured creditor's priority in his security up to the lesser of the full value of his security or the full value of his claim. In re Equity Funding Corp., 416 F. Supp. 132, 145 (C.D.Cal.1975).
Strict application of the foregoing principles would require that the process of compensating creditors in the run-of-the-mill corporate reorganization under the absolute priority rule proceed after the fashion of a liquidation, and it is tempting to demand of the reorganization process the kind of mathematical exactness that would result in such a case. There are, however, two important distinctions between liquidation and reorganization. First, in a reorganization the aggregate value of the debtor's assets is determined, not by a judicial sale, but by a hypothetical albeit expert calculation of their future worth to the enterprise. Second, claimants are satisfied not with cash, but with securities which reflect an apportionment of value in an ongoing business enterprise. It has long been recognized that these features of the reorganization process make it wholly unreasonable to expect that any plan will meet with precision the standards of the absolute priority rule. In every reorganization, numerous difficult issues of valuation must be resolved. The pressure of time and circumstance and the inherent uncertainty of forecasting the future of the enterprise seldom permit a certain determination of value.*fn5 On the distribution side, precise appropriation is necessarily handicapped by the recognized need to avoid overly elaborate and unstable capital structures.*fn6 These countervailing concerns find expression in the statutory requirement that reorganization plans must be "feasible," as well as "fair and equitable." Flexibility in the pursuit of feasibility has expressly been sanctioned by the Supreme Court:
The absolute priority rule does not mean that bondholders cannot be given inferior grades of securities, or even securities of the same grade as are received by junior interests. Requirements of feasibility of reorganization plans frequently necessitate it in the interests of simpler and more conservative capital structures. And standards of fairness permit it.
Practical adjustments, rather than a rigid formula, are necessary. The method of effecting full compensation for senior claimants will vary from case to case. . . . (W)hether in case of a solvent company the creditors should be made whole for the change in or loss of their seniority by an increased participation in assets, in earnings or in control, or in any combination thereof, will be dependent on the facts and requirements of each case. So long as the new securities offered are of a value equal to the creditors' claims, the appropriateness of the formula employed rests in the informed discretion of the court.
Consolidated Rock Products Co. v. DuBois, supra, 312 U.S. at 528-30, 61 S. Ct. at 686-87 (footnotes omitted). Accord, Institutional Investors, supra, 318 U.S. at 565-66, 63 S. Ct. 727; Northern Pacific Ry. v. Boyd, supra, 228 U.S. at 508, 33 S. Ct. 554.
The need for a pragmatic approach to the allocation of asset values was particularly great in this case. In any chapter proceeding, the practical problems of valuing the debtor's estate (and, more particularly, of valuing the assets subject to the liens of individual secured creditors) and of achieving a workable distribution to creditors are hard ones. In this case, those difficulties were many times compounded. Normally, the assets of the estate encumbered and unencumbered are in hand and readily subject to valuation by traditional methods. Here, as a result of the conveyance to ConRail under the RRRA, assets with a book value of.$3.2 billion had passed from the estate prior to the preparation of the Plan. Many creditors of the estate were secured in substantial part by those assets. Any final determination of the value of these assets to the ...