Before MOORE, Circuit Judge, and SMITH and HERLANDS, District Judges.
HERLANDS, District Judge.
This is an appeal by four common stockholders from an order of the district court approving the trustee's amended plan of reorganization of the debtor, Hudson & Manhattan Railroad Company, pursuant to Chapter X of the Bankruptcy Act, 11 U.S.C.A. § 501 et seq.
The problem of valuation presented in the reorganization proceeding was complicated by the possibility that some part or all of the debtor's commuter railroad plant might be purchased or condemned by a public authority at some indeterminate time in the future, at a price many times its present value, when such value is considered apart from the prospect of such a public takeover.
In his plan, the trustee concluded inter alia : "The present value of the entire enterprise, after giving full effect to assets, earnings, and prospects of sale of the railroad property to a public authority, is less than enough to satisfy in full the claims of the creditors of the Debtor." The plan, therefore, excludes both preferred and common stockholders from participation.The "present value" was not assigned a dollar amount. In an advisory report filed pursuant to section 173 of Chapter X of the Bankruptcy Act, 11 U.S.C.A. § 573, the Securities and Exchange Commission approved the trustee's plan in all pertinent respects and specifically concluded that the plan is fair and equitable in excluding the interests of the stockholders.
In approving the plan, the district court found that the debtor is insolvent; that neither preferred nor common stockholders have an interest in its assets; and that the highest price likely to be realized on public takeover of the railroad is forty million dollars. Adding this amount to the seventeen million dollars at which the real estate assets are valued, the court concluded that the maximum "potential value" of the enterprise thus obtained is less than the aggregate claims of all creditors.
Appellants argue that the court's finding respecting the maximum amount realizable on public acquisition of the railroad is based on evidence which is incompetent and insufficient, and that the debtor may in fact realize enough to satisfy the claims of all creditors, with something left over for preferred and common stockholders. Appellants contend that the plan, which excludes them, is therefore not "fair and equitable," within the meaning of section 174 of Chapter X of the Bankruptcy Act, 11 U.S.C.A. § 574. To cure this "defect," appellants proposed (and the district court rejected) an amendment of the plan which would give the stockholders cotingent interest certificates, clearly marked as such, to be called "Class C Common Stock." The holders of this "Class C Common Stock" would be entitled to any excess of the proceeds of sale of the debtor's railroad properties after senior security holders and creditors were satisfied in full.
The Supreme Court has given content and fixed meaning to the explicit statutory standard of fairness and equity by its full and absolute priority rule. In so far as it is pertinent here, that rule prescribes that stockholder interests shall not participate in a reorganization unless the debtor is solvent. Its assets must be valued at an amount in excess of the aggregate of the allowed claims of creditors. Before stockholders may participate at all without a fresh contribution by them "in money or in money's worth," creditors must be fully compensated in cash or securities of the value of their claims, both face amount and interest. Case v. Los Angeles Lumber Products Co., Ltd., 1939, 308 U.S. 106, 60 S. Ct. 1, 84 L. Ed. 110; Consolidated Rock Products Co. v. Du Bois, 1941, 312 U.S. 510, 61 S. Ct. 675, 85 L. Ed. 982. Even contingent participation of stockholders takes something that creditors would otherwise receive and is inadmissible in the usual case of an insolvent debtor. See Consolidated Rock Products Co., supra, 312 U.S. at page 529, 61 S. Ct. at page 686;*fn1 In the Matter of Central States Electric Corporation, 30 S.E.C. 680, 728-730 (1949).
The instant situation is somewhat unique in that a substantial realization on assets may occur in a single transaction. Fairness and equity permit an arrangement which makes the treatment of the various interests depend as little as possible on the relative timing of that transaction and the reorganization. An acceptable means of minimizing this factor of chance is to allow junior security holders, who otherwise would have no interest, to retain a contingent interest so that they may participate if the proceeds of the transaction exceed the claims of senior interests. See Country Life Apartments v. Buckley, 2 Cir., 1944, 145 F.2d 935, 936 (contingent proceeds of sale of assets); Central States Electric Corporation v. Austrian, 4 Cir., 1950, 183 F.2d 879, 882, certiorari denied 340 U.S. 917, 71 S. Ct. 350, 95 L. Ed. 662 (contingent proceeds of pending lawsuits).
Yet, not every present interest should necessarily be given a place in the queue. At some point, the following countervailing policies dictate that there must be a cut-off beyond which junior interests must be excluded. (1) To the extent that full compensation for their claims depends upon realization of uncertain prospects,*fn2 seniors must be compensated with the opportunity to participate in better-than-expected prosperity.*fn3 Otherwise, seniors would be victims of a "heads we win, tails you lose" bargain.*fn4 (2) Creation and distribution of a security practically certain to be worthless is contrary to the public interest. Such a security would be highly speculative, deceptive, and fraught with danger to investors.*fn5
The district court determined the cutoff point by finding the maximum figure reasonably likely to be realized on a sale of the railroad to a public agency. Finding that this figure, added to the value of the real estate properties, yielded a maximum potential value which was still below the aggregate claims of creditors, the court concluded that the stockholders should have no participation in the reorganization, even on a contingent basis. This approach to the problem is consonant with fairness and equity. Cf. Group of Institutional Investors v. Chicago, Milwaukee, St. Paul & Pacific R. Co., 1943, 318 U.S. 523, 536-538, 63 S. Ct. 727, 87 L. Ed. 959.
The debtor is a corporation organized in 1906, pursuant to the laws of the States of New York and New Jersey, by the merger and consolidation of three predecessor corporations. It is engaged in two types of business activities: the ownership and operation of the Hudson Tubes, an interurban electric railroad; and the ownership of certain real estate in downtown Manhattan, New York City, principally the Hudson Terminal Buildings, erected in 1907 and 1908.
The debtor's railroad system provides passenger service only, under the Hudson River, between stations in downtown and midtown Manhattan and stations in Jersey City and Hoboken. In conjunction with the Pennsylvania Railroad, the debtor operates a joint rapid transit service between Hudson Terminal and Newark.It has two uptown and two downtown tubes under the Hudson River, and about eight miles of double-track main lines. At the time reorganization proceedings began, the debtor had about two hundred motorized passenger cars, most of them acquired in the years 1908 through 1911, and never overhauled.
The district court found that the financial difficulties of the debtor stem from an initial over-capitalization with debt securities, combined with a progressively increasing squeeze on the railroad operations from rising operating expenses and loss of passengers to publicly financed vehicular crossings of the Hudson River by bridge and tunnel.
As of August 11, 1954 (the date these proceedings began by the filing of an involuntary petition in bankruptcy), the debtor had $46,339,405 in mortgage bonds outstanding, of which some $29,525,405 were First Mortgage and Refunding Mortgage Bonds and the balance of some $16,814,000 were Adjustment Income Mortgage Bonds. In addition, the debtor had outstanding 52,500 shares of 5% non-cumulative preferred stock, $100 par value, and approximately 400,000 shares of $100 par value common stock.
As of December 31, 1959, the aggregate of the claims of all creditors was about $66,825,000. Interest continues to accrue upon the bonds in the amount of $2,128,000 per year at coupon rates. Thus, counting the claims of creditors and the liquidation rights of preferred stockholders, there were, as of December 31, 1959, ...