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STANFORD LAW SCHOOL

Final Examination for Law 240-01

George Triantis

Autumn 2013 Five questions

Time: 3 hours Open Book

INSTRUCTIONS

1. This is a three-house in-class exam. It is open-book. In answering the questions, you

may consult any written or printed materials that you have brought into the examination
room, but you may not open any electronic documents or materials accessed over the
Internet during the exam.

2. There are five (5) questions. They are weighted equally. You may assume any omitted
facts that are reasonable in context, but you must do so clearly and explicitly.

3. Please double-space your answer. If you write, please write on every other blue-book
page and every other line.

4. Please type at the beginning of your examination the following statement: "I
acknowledge and accept the Honor Code." Sign (or type) your examination number (not
your name).

5. Unless your test paper is turned in promptly at the end of the examination period,
collectors will be required to report your examination as being late. The decision whether
to accept late examinations will be dependent on faculty action.

END OF EXAMINATION

Please remember to write, “I acknowledge and accept the Honor Code” and sign (or type) your
examination number.
 
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Question 1

Company F and Company M are affiliated entities that own and manage fast food franchises –
F’s franchises are in Florida and M’s in Massachusetts. The two companies have guaranteed
some of each other’s indebtedness and cash and other assets have been transferred between the
companies with minimal record-keeping. Their financial statements have been combined for
many years. Susan Jacobs was the majority owner and CEO of both, and her co-owners were
different in each company. In order to resolve a persistent personality conflict with her co-
owner in Florida (David), Susan agreed to buy out his interest for $1.9 million early in 2011.

The buy-out was leveraged as follows. Company F borrowed $1 million from Bank and gave a
second lien on its assets. Company F then transferred the $1 million to Susan as an advance on
her compensation as continuing CEO, and she used it to pay part of the purchase price for
David’s stock. David agreed to take a note from Susan for the balance of the price of $900,000,
secured by her stock in the company, and bearing interest at 5% per annum.

The year of 2011 was a terrible one for Company F. It was sued in tort by a number of
customers who got food poisoning from the restaurants and it was the victim of employee
embezzlement and fraud. The confluence of these events and the softness in the local markets
kept the company insolvent or on the verge of insolvency from the beginning of 2012 through
2013. The company was able to stay afloat thanks to the cash flow produced by its
Massachusetts affiliate, who remained solvent and profitable.

During 2012 and 2013, Company F paid David a total of $174,000 on account of Susan’s
interest and principal repayment obligations under the earlier stock purchase contract. The
Company also made its scheduled payments under its loan contract with the Bank, despite the
Company’s insolvency.

In December 2013, both Companies file for bankruptcy. The unsecured creditors’ committee
seeks your advice as to whether these facts raise avoidance actions and their likelihood of
success. Please advise.
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Question 2

In bankruptcy, Company moved for authorization to sell its assets under §363(b). At the first
stage, the debtor’s proposed sale procedure was approved by the court: including an order for a
public auction to be held in a month, and notice in the two leading trade journals and in local
newspapers. The auction was held and the winner was an entity established by the first lien
lenders. Their bid was for $4 million, in a combination of a credit bid of 3.2 million and cash of
$800,000. The debtor then brought a motion to the court to approve the sale, but it was opposed
by the unsecured creditors committee. On the morning of the hearing, counsel for the
committee presented to the court a new and higher bid from a third party that it valued at $4.5
million, comprising a combination of $500,000 in cash and promissory notes for the balance.

Suppose you are the bankruptcy judge and the issue of whether (and if so, how) to accept this
post-auction bid is one of first instance. You have only the statute and policy considerations
(no case law) as authority. How would you approach this case? Would there be other facts that
you would consider important?

Question 3

The debtor owns a multi-purpose building in Sacramento, whose units have been rented out as
retail stores, business offices, and residential suites. The acquisition of the building was
financed by a first lien held by Bank and the current outstanding indebtedness on that mortgage
is $8 million. To finance improvements of the residential apartments, Bank lent the Company
$1.5 million under a note secured by a second lien. Under the terms of the note, the semi-
annual payments under this promissory note were payable only out of a percentage of the net
rents from the residential units. After the first year following the improvement, however, the
Company did not have enough net rents (under the formula in the note) to make payments.

The debtor defaulted on both sets of lien obligations and the mortgagees began foreclosure
proceedings against the building. A foreclosure auction, however, attracted no bids above the
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reservation price of $6.8 million. When a new auction was scheduled, the debtor filed a petition
under Chapter 11 to stay proceedings.

The debtor is owned by a holding company that provides management services. The debtor
argues that the value of the building is greater to the parent than to third parties because of
holding company’s significant expertise in property management. So, the debtor proposes a
plan that provides for the conversion of the building to a fully residential use, the assumption of
the management contract with the parent, and the parent’s continuing holding of a controlling
share of the equity in the debtor. The plan estimates that the value of the repurposed building
would rise to $10 million from the current estimate of $6.8 million in 3 years.

As first and second lienholders, Bank objects to the plan because it wants the building sold and
the proceeds distributed. It exercises its election under 1111(b)(2) to hold a secured claim for
all of the $8 million indebtedness under the first lien. The debtor wants to cramdown the plan
against the objection of the Bank as a first lien holder. The debtor classifies the unsecured
claim of the Bank for $1.5 million (under the second lien note) separately from the class of
trade creditors (such as accountants, landscapers). The debtor proposes to pay these unsecured
trade claims in full over three months following confirmation of the plan. The debtor knows
that this class will accept the plan.

The Bank files objections to the plan and argues that the plan fails to satisfy the requirements of
1129(a), particularly subsections (3) and (10). What are the debtor’s chances of a successful
cramdown?

Question 4

The Bankruptcy Code provides safe harbors from automatic stay and avoidance actions, for
specified commodities and financial contracts. The primary rationale for these provisions was
to protect financial and commodities markets from systemic liquidity crises that might be
triggered by the defaults of a bankrupt party. Please comment on the additional rationale for
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these provisions that is advanced in the academic article cited in Re National Gas Distributors
(4th Cir. 2009)(Supp. at 51):
“Additionally, [but for the safe harbors,] a debtor in bankruptcy would be free to “cherrypick”
multiple contracts with the same party … “In-the-money” contracts could be assumed; “out-of-
the-money” contracts could be rejected. In this way, the debtor could lock-in gains on
profitable contracts and (due to its insolvency) limit liability for losses under unprofitable
ones.”
Apart from threatening contagion or a domino effect in financial markets, is this asymmetry
between assumption and rejection under the Bankruptcy Code – and the opportunity to cherry
pick -- sufficiently troubling at a broader level so as to make us doubt the wisdom of the
bankruptcy framework for dealing with executory contracts? Please discuss. If it’s helpful in
your discussion, consider a retailer in bankruptcy with hundreds of executory supply and
delivery contracts, some of which are now at below-market prices and others at above-market
prices.

Question 5

Suppose a debtor moves under 364 for authorization for DIP financing. The debtor, however,
has an asset that is not essential to the going concern (for example, a passive stock holding in a
publicly listed company, a plot of real estate that is rented out to third parties, an art collection
in its offices). Should such a debtor be entitled to any DIP financing without first being
required to liquidate all non-core asset holdings?