Before FRIENDLY, KAUFMAN and MARSHALL, Circuit Judges.
The issue is the propriety of an order of Judge Edelstein, in the District Court for the Southern District of New York, denying a motion by the Securities and Exchange Commission (hereafter the SEC), to dismiss the petition of Grayson-Robinson Stores, Inc. (hereafter "Grayson" or "the debtor"), a large retail chain, for an arrangement under Chapter XI of the Bankruptcy Act unless the petition was amended or a new petition filed so that the proceedings would continue under Chapter X. The SEC's motion was supported and its appeal has been joined by Katherine B. Ladd and Connecticut General Life Insurance Company (hereafter referred to collectively as a single landlord), who have filed a claim based on Grayson's guarantee of a lease entered into by a subsidiary that has defaulted.*fn1 Weighing the conflicting considerations in the light of the controlling authorities, we have concluded to affirm.
The facts have been so painstakingly stated in Judge Edelstein's opinion, 215 F.Supp. 921, that we shall limit ourselves to the essentials:
Grayson, a California corporation, is a nation-wide chain selling women's and children's apparel. All the stores are separately incorporated, and many of them are operated under leases entered into by the subsidiary and guaranteed by the parent. Until October, 1962, Grayson also woned and operated a "Peerless-Willoughby" division engaged in the retail sale of photographic and audio equipment. Prior to November, 1960, the controlling stock interest in Grayson, some 32%, was owned by Hyman P. Kuchai and Philip S. Harris, who also controlled the S. Klein department stores. Until 1956 Grayson owned all the stock of Klein; in that year 92% was distributed to the debtor's stockholders.
On November 6, 1960, Kuchai and Harris entered into a contract to sell their stock in the debtor to Maxwell H. Gluck, who was and is sole owner of Darling Stores Corporation, another retail chain selling women's apparel. The consideration was $2,467,500, of which $715,575 was payable in cash at the closing and the balance on January 5, 1961. Kuchai and Harris made it a condition that Grayson be released from a guarantee of a 4 1/4% note of Klein to Prudential Insurance Company, then outstanding in the sum of $7,375,000, which imposed restrictions on both Klein and Grayson, with a breach by either working a default on both. This release was accomplished by a three-cornered transaction in which Grayson transferred to Klein the 8% of Klein stock (68,250 shares) owned by it, Prudential released Grayson from its guarantee, and Klein agreed to purchase the 4 1/4% $7,375,000 note. It financed the purchase by paying $1,350,000 and issuing a new 5.7% note in the amount of $6,775,000 to Prudential, which credited Klein with $6,025,000 against the 4 1/4% note and delivered to Klein for cancellation another 5 3/4% $750,000 note previously issued by Klein in place of a required prepayment on the 4 1/4% note.*fn2 At the annual meeting of Grayson's stockholders on November 23, 1960, Gluck, Stanley Roth (previously president of Darling), and Eugene F. Roth, an attorney, were elected as directors. Gluck became chairman of the board, and Stanley Roth, who resigned as president of Darling, became president. He told a special stockholders' meeting on December 19 that the new management was "sensitive to the need for developing added volume and profits" and that "Among others we have been giving some consideration to ways of accomplishing the objective by some arrangement with Darling Stores Corporation."
As a result of a study conducted by the well-known accounting firm, S. D. Leidesdorf & Co., a plan to that end was shortly evolved. Under this plan Grayson purchased all of Darling's inventory, supplies, and New York office equipment at the lower of cost or market, and agreed to operate Darling's stores and leased departments for a minimum of five years; the compensation for this service was set at 90% of the stores' "operating profits", which were to be determined without provision for general and administrative expense. The plan was embodied in an Operating Agreement entered into by Grayson and Darling on January 5, 1961 - the same day on which Gluck was obligated to pay Kuchai and Harris approximately $1,751,925 as the balance of the purchase price of the Grayson shares. This sum was in fact paid to Kuchai and Harris by or for the account of Darling, which thereby acquired a proportionate interest in the Grayson stock being purchased; Darling received $500,000 from Grayson on January 19, 1961, in part payment for the inventory, supplies, and equipment and another $750,000 on February 2. By a separate agreement dated January 6, 1961, Darling guaranteed that for 1961 Grayson's 90% of the operating profits would be no less than 6% of sales; however, liability under the guarantee was limited to $500,000, and it was further provided that any amounts charged to Darling under the guarantee would be recouped by it out of Grayson's 90% compensation in years subsequent to 1961. Darling was also to receive $210,000 on August 14, 1962, for certain fixtures purchased by it subsequent to the Operating Agreement and 0.92% of sales as a rental for fixtures earlier acquired.
The new management of Grayson embarked upon a substantial expansion program which took the form of opening leased departments to sell apparel in established discount stores - a method of operation in which Darling had already engaged and which was thought to have advantages in the way of lower capital and overhead costs more than compensating for the lower profit margin. This expansion imposed a severe strain on the debtor's working capital. It sought to alleviate this by increased loans from Bankers Trust Co., as security for which it pledged the stock and notes of its profitable photographic subsidiaries. In a further expansion move it agreed, on July 5, 1961, to buy from Shoe Corporation of America 51% of the stock of A. S. Beck Shoe Corporation for $4,900,000 of 5% convertible debentures (subordinated to bank and other borrowings but not to trade creditors), and to purchase Beck shares from other stockholders on the same terms. The Shoe Company shares were acquired on December 4, 1961, the Gluck management took control of Beck on December 15, and 33 shoe departments selling Beck shoes were later opened in Grayson or Darling locations.
This rapid expansion without increase of the equity base or other long-term financing proved to be unwise. As stated in Grayson's Annual Report for the year ended July 28, 1962, early in 1962 "Pressure to liquidate the major bank loan developed. When knowledge of this pressure became public, serious limitations in trade credit resulted. The flow of merchandise, which is the life blood of the business, was gravely affected." In an effort to meet its problems, Grayson placed a $10,000,000 convertible debenture issue in registration with the SEC on January 26, 1962, and also a $4,702,500 issue of subordinated convertible debentures to be offered to the minority stockholders of Beck pursuant to the agreement with Shoe Corporation of America. However, the registrations had not been completed when the stock market experienced its radical decline in May, 1962, whereupon the underwriter of the $10,000,000 issue withdrew; both registration statements were subsequently withdrawn. Meanwhile, on March 14, 1962, Grayson secured a $2,500,000 sixmonth loan at 6% from Schroder Trust Company secured by pledge of the Beck stock and a personal guarantee of Gluck collateralized by deposit of $1,000,000 in other securities; on March 26 it borrowed another $2,500,000 for one year from James Talcott, Inc., at 1/30% per day, secured by customer accounts receivable of 130 stores. Despite all this, debts to trade creditors mounted to $10,000,000, and the flow of merchandise was drastically curtailed.*fn3 On August 14 a petition under Chapter XI was filed.
On August 20 a Creditors' Committee of 40 persons was elected at a creditors' meeting. One of its co-chairmen represented American Credit Indemnity Co., with a claim of $350,000; the other members were merchandise suppliers with claims of varying amounts, and a representative of display fixture creditors, the total claims represented by committee members being some $2,381,000. At the suggestion of Referee Herzog, a sub-committee of 13 was chosen to act as the Official Creditors' Committee under § 338 of the Bankruptcy Act. The Committee retained counsel and accountants to investigate the debtor's affairs, and a merchandising subcommittee supervised purchases to insure that the debtor did not over-commit itself. With the approval of the court the photographic subsidiaries were sold for approximately $5,800,000, an amount sufficient to liquidate the Bankers Trust Company loan, to discharge liens of more than $400,000 perfected by certain merchandise creditors, and to yield some surplus in cash. The debtor also undertook a rehabilitation program estimated to produce annual savings of $4,000,000 through reducing home office expenses, store payrolls, and rentals, and through the closing of 30 unprofitable stores; further savings from rent reductions and store closings are anticipated.
On November 14 and 20, and December 3, 11 and 21, examinations under § 21(a) of the Bankruptcy Act were held. Wood (treasurer of the debtor), Gluck, Sherman (the Leidesdorf partner who had advised as to the Operating Agreement) and Stanley Roth were examined. The examination, recorded in 377 pages of transcript, was conducted almost solely by counsel for the Creditors' Committee under the supervision of Referee Herzog, but counsel for the appellant landlord save the Referee's quite proper desire to control the was present on all but the first day's examination,*fn4 and we find nothing to indicate any restraint on his questioning save the Referee's quite proper desire to control the examination so as to avoid needless repetition.
In October, 1962, it became known that the SEC was considering the filing of an application under § 328 of the Bankruptcy Act, as amended, 1952, to require the debtor's proceedings to be transferred to Chapter X. After various conferences, action by the SEC was postponed until after the Christmas season, the debtor assuring the SEC that no attempt would be made to rush through an arrangement before the SEC could move. Meanwhile negotiations with creditors with respect to an arrangement proceeded. On January 3, 1963, the SEC made its motion; a few days thereafter the proposed Plan of Arrangement was filed, to be followed on February 1 by an amended Plan.
The amended Plan provides for the payment of priority claims and also of interest due and unpaid on the subordinated convertible debentures held by Shoe Corporation of America, the latter payment being conditioned on the indenture trustee's rescinding a declaration accelerating the principal.*fn5 It does not mention and thus apparently leaves undisturbed the $2,500,000 secured loan from Schroder Trust Company and any borrowings secured by assignment of accounts receivable. All unsecured creditors (other than holders of the subordinated convertible debentures) are to receive non-interest-bearing "General Debentures" in the full face amount of their claims; these are to be paid off in not less than 11 years from the date of confirmation, with earlier payments required as described in the margin.*fn6 Gluck agrees to deposit with counsel for the Official Creditors' Committee, as Trustee, 100,000 shares of Grayson stock; for three years he may repurchase any or all these shares for $10 per share; at the end of the three years the Trustee is to distribute the shares and/or the receipts from Gluck to the unsecured creditors. The Plan also provides for various alterations in the Operating Agreement with Darling Stores favorable to Grayson. Darling would abandon its right to recoup $492,000 which it paid to Grayson under its guarantee of minimum compensation for the first seven months; Grayson would receive 100% rather than 90% of the store operating profits; and Gluck consents to rental reductions aggregating some $124,000 a year in the case of certain Darling stores leased from corporations owned by him, he being entitled to take back any of these stores on 90 days' notice and the debtor being entitled on like notice to close any of them and be relieved of all further obligation regarding them. Darling is to forgive a balance of $63,000 due from Grayson on July 28, 1962 and the $210,000 payable to it for fixtures, and also agrees to limit the payment of 0.92% of sales as fixture rent to $230,000 a year. Changes beneficial to Grayson are also to be made in the provisions with respect to termination and extension of the Operating Agreement. The aggregate value of these various concessions made by Gluck either directly or through Darling was estimated as approximately $4,500,000. The Plan further provides that so long as 40% of the General Debentures are outstanding, the debtor will not, without prior approval of the Official Creditors' Committee, expand its operations (other than by adding units in Woolworth stores), increase the compensation of its chairman or president or any members of their families, repay any General Debentures except pro rata or any subordinated convertible debentures except pro rata with General Debentures, or retire or purchase common stock. The court is to retain jurisdiction until all the payments to general creditors have been made.
The SEC's motion was supported by an affidavit of one of its attorneys. After setting forth the recent history of the debtor, it alleged, as reasons for the relief requested, the "Financial Inadequacy of Chapter XI," to wit, that successful reorganization would require the raising of new capital; "The Need for Investigation" of the transactions outlined above and other matters, particularly "the competency of management"; the desirability of bringing the debtor's many subsidiaries into the reorganization, as could readily be done under Chapter X, § 129; and the various procedural and substantive safeguards ...