Cutting in Line: How Shareholders and Bondholders Are Being Paid Ahead of Trade Creditors in Chapter 11—Thanks to the Securities and Exchange Commission and The Sarbanes-Oxley Act
Written By Scott Blakeley, Esq.

Headlines of corporate fraud within public companies, from Enron to Adelphia to WorldCom, prompted the U.S Congress to overwhelmingly pass federal legislation providing for accounting reform and requiring more accurate financial disclosure and reporting from public companies. This new federal legislation penetrates the area of corporate governance, which traditionally had been left to the states. The Sarbanes-Oxley Act of 2002 (SOA) was signed into law in July 2002 to combat the wave of accounting and financial reporting scandals and corporate bankruptcies.

SOA focuses on the conduct of corporate officers and public accounting firms and adequate disclosure in public company financial statements. SOA provides that the Securities and Exchange Commission (SEC) enforces the legislation and has earmarked $766 million for SEC enforcement. A provision of SOA allows for the SEC to direct money collected from a fine and civil penalties of the company to a restitution fund for shareholders, not vendors. Prior to SOA, the SEC could only repay defrauded shareholders through money collected through disgorgement actions, as fines and civil penalties went to the U.S. Treasury.

WorldCom filed the largest chapter 11, which was triggered by massive financial fraud. WorldCom agreed to pay shareholders and bondholders $750 million to settle fraud charges brought by the SEC under SOA. The settlement, the largest of its kind, is not only remarkable as to its size, but also in that shareholders, which are junior in priority to vendors’ pre-petition claims, and bondholders, that are equal to vendors’ pre-petition claims, are paid ahead of creditors. Under the plan of reorganization proposed by WorldCom, vendors received stock in the reorganized debtor.

The proceeds from the settlement going to shareholders and bondholders clashes with a fundamental principle of the bankruptcy laws, that of the long-standing priority scheme wherein creditors are paid ahead of shareholders. Indeed, until unsecured creditors are paid in full, which will not happen in WorldCom or Enron, shareholders are not to receive payment.

Nothwithstanding the priority scheme, shareholders are able to cut ahead of vendors’ pre-petition claims as the government is treated as a priority creditor and paid first. But the conflict with the priority scheme is that shareholders are rewarded at the expense of creditors. While shareholders and bondholders were defrauded by WorldCom management, vendors were likewise defrauded. Using SOA, the government is now giving shareholders (and bondholders) a distribution that otherwise could be distributed to vendors who are higher on the priority scheme. The SOA operates outside of the Bankruptcy Code.

The SEC is on a mission to protect the ordinary shareholder and is using SOA for the benefit of shareholders, to the detriment of vendors, where the insolvent customer has issued fraudulent financial statements. One of the risks for vendors as the SEC now champions the shareholder and bondholder is that shareholders may now raise arguments in chapter 11 proceedings that the preferred treatment they received in WorldCom and Enron should happen in their case. More troubling is that in WorldCom and Enron, as well as virtually all financial fraud cases, investors take risk when they purchase stocks.

Likewise, vendors take risk when they extend credit. Vendors, like shareholders and bondholders, were defrauded by WorldCom and Enron management. In other words, the SEC proposes to transfer hundreds of millions of dollars from one innocent party, creditors and vendors, to another innocent party, shareholders and creditors. Shareholders and bondholders should not be extended a safety net through the SEC’s prosecution of SOA, and upend the priority scheme established by Congress with the bankruptcy laws. A credit professional is well aware of the importance of due diligence and credit analysis to reduce the risk of delinquent accounts. Likewise, the shareholder and bondholder should be investigating before investing. The SEC’s action merely allows shareholders and bondholders to investigate less.

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Key Issues Regarding the Retention and Use
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