Section 1145 of the Bankruptcy Code: The Intersection of Bankruptcy and Securities Laws

Updated 12/20/2024

Introduction

Section 5 of the Securities Act of 1933 provides that it is unlawful for an issuer or holder of securities to offer or sell any security except pursuant to a registration statement filed with the Securities and Exchange Commission (SEC), unless a statutorily prescribed exemption is available. The registration process entails preparation of a prospectus, review and comment on the prospectus by the staff of the SEC, and making the prospectus available to investors. State laws also subject the issuance of securities to registration, although in most cases the state laws will be preempted by federal statute. Securities can be issued to accredited investors and other sophisticated investors in private placements, although these securities will be “restricted” — that is, they will not be freely tradeable in the U.S. public securities markets.

In a reorganization under Chapter 11 of the U.S. Bankruptcy Code, the reorganized debtor will almost invariably be issuing new securities to some of its creditors. Without an exemption from registration with the SEC, the reorganized debtor could not issue freely tradeable securities to such creditors, and generally could not issue the securities at all to nonaccredited investors. Complying with the registration requirements, on the other hand, could be time-consuming and distracting, and is never a practicable option.

Enter Section 1145 of the Bankruptcy Code. When available, Section 1145 accomplishes two things: It permits the offer and sale of securities under a bankruptcy plan of reorganization to all creditors, including those that are nonaccredited, and it deems those securities to have been issued in a public offering, so that the securities are not restricted and generally can be immediately resold in the public U.S. securities markets by non-affiliates of the reorganized debtor.^[1]

The application of Section 1145 is not always straightforward under now-common bankruptcy scenarios that were likely not envisioned when the Bankruptcy Code was adopted in 1978, and in certain cases the exemption of Section 1145 may be unavailable. Sometimes debtors may elect to forgo the availability of Section 1145, notwithstanding that this may disadvantage certain creditor groups. This article reviews the basics of Section 1145, discusses its application to real-world scenarios and addresses reporting and certain other securities law issues applicable to securities issued under a bankruptcy plan.

The Basics

Section 1145 will be available for securities issued in bankruptcy if:

1. The securities are issued under a plan.^[2]
2. The securities are issued by a debtor or a successor to a debtor.^[3]
3. The securities are issued (i) in exchange for a claim against a debtor, (ii) in exchange for a claim for an administrative expense in the case, or (iii) principally in such an exchange and partly for cash or other property.

The ‘issued in exchange’ requirement

The availability of Section 1145 most often turns on whether the securities under the plan satisfy the requirement that they be issued in exchange for the prescribed consideration.

• Securities issued in exchange for a claim against a debtor. When a plan provides nothing more than that holders of a pre-petition claim against the debtor will receive securities of the reorganized debtor, the applicability of Section 1145 is rarely in doubt. The claims can take the form of bonds or other types of debt securities, bank debt, trade claims, claims for rejected contracts or any other claims against the debtor that are recognized under the Bankruptcy Code.
• Securities issued in exchange for a claim for an administrative expense in the case. Section 503(b) of the Bankruptcy Code contains a long list of items that are deemed administrative expenses but that are not typically paid in the form of securities of the reorganized debtor.^[4]It has become customary practice, however, to apply the administrative expense provision of Section 1145 to other types of expenses that are more likely to be paid in the form of securities. These include fees and premiums in respect of investors’ obligations under a backstop or similar agreement.
• Securities issued principally in exchange for a claim against a debtor and partly for cash or other property. This prong of the exchange criterion is often the subject of the most analysis and discussion among counsel to the debtor and the creditors. Under this prong, Section 1145 treatment will be available for securities issued to a creditor under a plan even though the creditor is required to pay consideration — usually cash — for the securities, provided that the securities received are “principally” in exchange for the claim. This is often referred to as the “principally/partly test” and its most common application is to rights offerings, as described in the following section.

Rights Offerings

A significant majority of large Chapter 11 plans include a rights offering of equity and/or debt securities to creditors as a component of the exit financing. Although the creditors that subscribe to the rights offering are paying cash for the securities they acquire, the staff of the SEC has taken a holistic view that combines the securities issued under the plan in exchange for a creditor’s claims and the securities acquired by the creditor in the rights offering. The staff then looks at the consideration “paid” for these securities in the aggregate, including the value of the claims and the cash paid in the rights offering. If the value of the claims being exchanged exceeds the value of the cash — or according to some practitioners, the value of the cash is no more than 75% of the value of the claims being exchanged — the principally/partly test will be satisfied and the securities issued in the rights offering will also qualify for treatment under Section 1145.

While the cash consideration is easily quantifiable, the value of a claim is not. For starters, the value of a claim is not its face amount, but rather the value ascribed to it in the bankruptcy. There are a number of ways used to estimate the value of a claim:

• For claims such as debt securities or trade claims that have a trading market during the case, claim value could be based upon the trading prices of the claim in the market, as of a recent date prior to commencement of the rights offering.
• Most often, claim value is determined based upon the value of the securities issued in exchange for the claims under the plan, prior to giving effect to the rights offering. For equity securities, the value is usually derived from the total equity value ascribed to the reorganized debtor under the plan by the debtor’s professionals.[5]
• There is sometimes added to claim value a price ascribed to the right to participate in the offering, as that participation right is a consequence of the claim. Where, as is often the case in an equity rights offering, the acquisition price in the rights offering is struck at a discount to plan value, the price of the rights can be derived from the discount.

A simplified example:

Assume a plan value of $10 million for the equity of the reorganized debtor, that there is $20 million in face amount of claims against the debtor in the classes that are receiving equity on account of such claims, and that all of the equity is being distributed to such claimants. Under the plan, such claimholders receive 100 shares for each $1,000 in face amount of claims, or 2 million shares in the aggregate. The plan thus ascribes a value of $5 to each share of the reorganized debtor’s stock. Assume further that for each $1,000 in claim amount, a claimholder is entitled to subscribe for 50 shares at $4 per share, with the $1 discount approximating the price of a right. The value of $1,000 in face amount of claims would therefore be (i) $500, based on the value of the shares issued in exchange for the claims, plus (ii) $50, the value of the rights received in the offering based on the discount to plan value, or a total of $550. As the aggregate cash price for the securities acquired in the rights offering is $200 (for each $1,000 in claim amount), the principally/partly test would be comfortably satisfied.

If, however, in the rights offering each holder had the right to subscribe for 200 shares for each $1,000 in claim amount, then the value of the claims per $1,000 in claim amount would be $500 + $200, or $700, while the cash acquisition price in the rights offering would be $800 (for each $1,000 in claim amount). The rights offering would therefore fail the principally/partly test. As a consequence, the shares issued in the rights offering would not qualify for treatment under Section 1145 and the rights offering generally could only be extended to accredited investors or, in some cases, bifurcated into two rights offerings, with one sized to meet the Section 1145 requirements and the remainder “stub” rights offering being subject to private placement restrictions.

When Section 1145 May Be Unavailable

There are various common situations in which claimholders may not be able to rely on Section 1145, and, at least in part, the shares they receive under the plan of reorganization may be restricted and hence not freely tradeable.

• Prepackaged plans. In a prepackaged plan, a debtor solicits consents to a bankruptcy plan of reorganization in advance of filing for Chapter 11, and necessarily before the plan is presented to and approved by the bankruptcy court. If, as is almost always the case, the plan contemplates the issuance of securities to the pre-petition creditors that are being solicited, the consent solicitation may be viewed as the unregistered offering of securities. Assuming no other exemption from registration is available,[6] the consent solicitation would have to be made in reliance upon a private placement exemption and directed solely to accredited investors.
  
  It has been suggested that Section 1145 may not be relied upon for the issuance of securities under a prepackaged plan, in accordance with the general principle that an offer that begins as a private placement cannot be completed as a public offering. However, the SEC staff in certain informal communications has indicated that it would not object to an issuer relying on Section 1145 to issue securities in a prepackaged plan, assuming all of the statutory conditions to its availability were satisfied.

• Rights offerings. If a rights offering would not be exempt under Section 1145 for failure to satisfy the principally/partly test discussed above, a debtor might bifurcate the rights offering into two parts. One part of the rights offering, sized to satisfy the principally/partly test, could be made to all creditors, both accredited and nonaccredited investors. The second part would be made only to accredited investors in reliance on a private placement exemption.

Continuing the prior example:

Instead of a single rights offering for 200 shares per $1,000 face amount of claims, the rights offering is bifurcated. The first offering is for 160 shares per $1,000 face amount of claims. The claim value per $1,000 face amount would then be $500 + $160, or $660, and the cash consideration would be $640 per $1,000 face amount, so that the principally/partly test is satisfied.^[7]This rights offering could be made to both accredited and nonaccredited investors. A second rights offering of 40 shares per $1,000 claim amount would be made only to accredited investors.

The exclusion of nonaccredited investors can also be addressed by paying them in cash the value of the rights that they would otherwise have been entitled to receive had they been permitted to participate in the rights offering. Smaller investors are often uninterested in investing new money in a rights offering, and where the rights offering is directed to bondholders or similar investing groups,^[8]the number of nonaccredited investors is likely to be relatively small in any event. A solution that pays cash to nonaccredited claimholders, rather than bifurcating the rights offering, may be a superior way (assuming the amount of cash paid does not significantly impair future liquidity) of satisfying both the accredited and nonaccredited claimholder constituencies.

• Backstop agreements. Virtually all rights offerings in bankruptcy will be “backstopped” by a small number of investors, who agree to purchase the securities that are not taken up by others in the offering. While these investors do not need to be creditors, since the backstop arrangements are made pursuant to a separately negotiated agreement, the backstopping investors typically are creditors of the debtor.
  
  The backstopping investors may acquire securities in the rights offering in a variety of capacities:

• • They may acquire securities by exercise of the rights allotted to them, like any other claimholder in the appropriate class. Assuming the principally/partly test is satisfied, these securities will qualify for issuance under Section 1145.
  • The backstopping investors may also receive fees that are payable either wholly or partly in the form of securities. These securities will qualify for treatment under Section 1145 as securities issued in exchange for an administrative claim, even if the rights offering itself does not satisfy the requirements of Section 1145.
  • These investors may acquire securities taken up on account of their backstop obligation. These latter securities generally will not qualify under Section 1145 because they will not be issued in exchange for a claim and their issuance generally will be pursuant to a private placement exemption.^[9]
  • Finally, in many cases a portion of the rights offering is allocated to the backstopping investors and is referred to as a “holdback.” Holdback securities will likewise generally not be issued in exchange for a claim or qualify under Section 1145.^[10]
    
    
• Transferable rights. The rights issued in a rights offering may be either transferable or nontransferable. If the rights are transferable, creditors that do not wish to invest new money can monetize the rights that they receive by selling those rights to others who have an interest in making a new or additional investment in the reorganized debtor. The exercise of transferred rights would not qualify for treatment under Section 1145, if those exercising the transferred rights will not be doing so in exchange for a claim.^[11]

The Treatment of Affiliates

As noted, securities issued pursuant to Section 1145 will be freely transferable upon issuance for purposes of the Securities Act, other than by affiliates of the reorganized debtor.

• Considerations for affiliates. Securities that qualify for Section 1145 treatment but that are acquired by affiliates are not restricted but are regarded as “control securities,” no different than any other securities held by affiliates of an issuer.^[12]They can be sold immediately upon issuance pursuant to Rule 144, in which case all requirements of the rule other than the holding period apply — most importantly, satisfaction of the volume limitations, but also the public availability of information regarding the reorganized debtor, observing the required manner of sale (through a broker or to a market maker) and the filing of a Form 144, if applicable. Affiliates can also sell the securities in private transactions, but in that case the purchaser will acquire “restricted securities” that are subject to a six-month holding period (or 12-month period for non-reporting companies) before they can be resold in the public markets.
  
  
• Affiliate determination.^[13] The determination of whether a former creditor is an affiliate of the reorganized debtor will be made in accordance with the same factors utilized outside the bankruptcy context. These factors include principally the size of the creditor’s post-emergence equity holdings — the larger the holdings, the more likely a creditor will be deemed an affiliate^[14]— and whether the creditor will have representation on the board of the reorganized debtor or other indicia of influence over control of the reorganized debtor. In computing the size of the creditor’s post-emergence holdings, convertible preferred stock, convertible debt and warrants will be included in accordance with the customary calculation procedures of the federal securities laws.^[15]
  
  It is important for a claimholder to understand and evaluate in advance of emergence whether it will be regarded as an affiliate of the reorganized debtor. This understanding will inform its exit strategy for the securities that it receives, and in particular whether it will need registration rights.

• Registration rights. Because of the limitations on resale applicable to affiliates of the reorganized debtor, affiliates will invariably negotiate for post-emergence registration rights. These registration rights empower the affiliates to cause the reorganized debtor to register^[16]with the SEC their securities for resale at such times and from time to time as the affiliates determine, subject to customary conditions and limitations. While the terms of registration rights agreements are relatively standard, creditors and the issuer will negotiate regarding the quanta of various terms, including the number of demands that the creditors can make for a registered offering, either annually or in the aggregate; the minimum size for a registered offering; the minimum holdings of creditors that may require the issuer to conduct a registered offering; and the extent of annual blackout periods during which the registration statement cannot be used. If the debtor is not an issuer that files reports with the SEC under the Securities Exchange Act of 1934, there may also be IPO trigger rights that are negotiated for.
  
  If the debtor is an issuer that files reports with the SEC under the Exchange Act — and continues to report during the bankruptcy process — the registration rights agreement will usually require the reorganized debtor to file a resale registration statement and use its commercial efforts to have it declared effective, shortly after emergence (sometimes subject to a delay for administrative reasons, such as fresh-start accounting issues). Otherwise, there will likely be a period of time before the registration statement is declared effective and available for resales. In some cases, even where the debtor has been reporting, the registration may be deferred, either because the reorganized debtor is engaged in acquisition negotiations or other activities that are not ripe for public disclosure or because the creditors prefer to wait for an appropriate market window before listing and widespread trading commences.

• Disclosure obligations. The disclosure obligations of affiliates and other significant beneficial equity owners will depend on whether the securities of the reorganized debtor will be registered under Section 12 of the Exchange Act, as will be the case when the reorganized debtor’s shares are listed on an exchange at emergence.
  
  If the shares of the reorganized debtor will be registered under the Exchange Act, holders of more than 5% of a registered class of the issuer’s equity securities^[17]will be required to file reports under Section 13(d) of the Exchange Act — on Schedule 13G or 13D, generally depending on whether the holders have passive or activist intentions^[18]— and holders of more than 10% of the issuer’s equity securities will also be required to report their holdings and transactions under Section 16(a) of the Exchange Act. In addition, such 10% holders will generally be subject to the “short swing” recapture provisions of Section 16(b), which provide for disgorgement of profits on any “matching” transactions within a six-month period. If an institutional creditor will be subject to post-emergence reporting obligations under the Exchange Act, it is important for the creditor to coordinate early in the process with its internal compliance function and counsel.^[19]

The Relative Waning of Section 1145 for Ad Hoc Group-Driven Restructurings

Some practitioners have observed that the importance of Section 1145 compliance in formulating Chapter 11 plans of reorganization may have waned in recent years for certain fact patterns. More and more, large ad hoc groups of institutional investors, with relatively large collective claims against the debtor, have driven the reorganization process. At the same time, the unsecured creditors committee, representing a sea of smaller, uncoordinated claimholders, has receded from its prior perch of principal importance. The ad hoc groups, often led by one or more outsize creditors that are likely to be affiliates of the reorganized debtor in any event, are less likely to be concerned with the post-emergence liquidity of the smaller creditors, and so the availability of Section 1145 may not loom as large in their thinking about how best to achieve an optimal capital structure for the debtor post-emergence.^[20]One consequence of the somewhat diminishing attention paid to Section 1145 in recent bankruptcy cases has been large, non-Section 1145-compliant rights offerings, with a six (or for non-reporting companies, 12)-month holding period for the acquired securities under Rule 144.

Conclusion

Creditors that receive securities under a bankruptcy plan of reorganization should be aware of the application of the federal securities laws, particularly if the debtor emerges as a public company registered with the SEC under Section 12 of the Exchange Act. Section 1145 of the Bankruptcy Code will exempt certain issuances of securities received under the plan from the registration requirements of the SEC, with the consequence that these securities will be freely tradeable other than by affiliates of the reorganized debtor. Securities that do not qualify for issuance pursuant to Section 1145 and securities received by affiliates will not be freely tradeable upon emergence. Regardless of whether securities qualify under Section 1145, creditors receiving significant amounts of equity securities under a plan may be obligated to file beneficial ownership reports with the SEC.

It may take time to sort through the issues and related filing requirements, which can involve matters of judgment and coordination between counsel for the creditors and the debtor. Accordingly, it is best practice for creditors, the issuer and counsel to focus on the securities law issues early and regularly during the process.

^[1] _{Section 1145(a) provides the exemption from registration. Section 1145(c) deems securities issued in reliance on Section 1145(a) to have been issued in a public offering.}

^[2]_{This condition would not be satisfied in a sale of debtor property under Section 363 of the Bankruptcy Code, in which a subsidiary or assets of the debtor are sold in exchange for stock of the acquiror and the stock is distributed to creditors.}

^[3]_{This condition would not be satisfied if creditors receive securities of an affiliate of the debtor that is not itself participating in a joint plan with the debtor in bankruptcy.}

^[4] _{Among other things, administrative expenses include wages, salaries and commissions for services rendered to the debtor, fees of professionals employed by the debtor, expenses of a committee or creditor making a substantial contribution to a case, and expenses of an indenture trustee that makes a substantial contribution. Such expenses are not usually paid in the form of securities.}

^[5]_{This same value is often used to determine the acquisition price for the securities sold in an equity rights offering, which is typically priced at a discount to plan value.}

^[6]_{For example, there could be a number of reasons why the debtor cannot rely on Section 3(a)(9) of the Securities Act, which exempts exchanges of securities for other securities of the same issuer, subject to certain conditions. Creditors may be required to put in new money, a solicitation agent may be used, the claimholders may be trade creditors that do not hold a security or new securities may have a different issuer from the exchanged securities.}

^[7]_{This assumes that a simple majority of claim value is sufficient to satisfy the principally/partly test. As noted in the text, some practitioners recommend a higher percentage of claim value.}

^[8]_{If the creditor class includes trade creditors, there could be a meaningful number of nonaccredited investors, so making the rights offering available only to accredited investors may not be appropriate.}

^[9]_{In contrast, if the backstop arrangements are made available to all creditors of a class, the securities acquired pursuant to the backstop commitments may qualify under Section 1145, assuming satisfaction of the principally/partly test.}

^[10]_{Widely available holdback securities may also be open to a Section 1145 analysis similar to that in the previous note.}

^[11]_{If rights are transferable, there will likely be fewer securities available for purchase by the backstopping investors. Whether these investors will advocate for or resist the issuance of transferable rights will depend on their investment thesis for the reorganized debtor and their appetite for acquiring additional securities.}

^[12]_{Section 1145(b)(1)(D) of the Bankruptcy Code would seem to indicate that Section 1145 is unavailable for securities issued to affiliates of the reorganized debtor. The SEC staff, however, takes the position that Section 1145 is available but that the securities are “control securities” (not “restricted securities” under Rule 144).}

^[13]_{If a creditor is an affiliate of the reorganized debtor on emergence but then ceases to be an affiliate (for example, because it has reduced the size of its holdings), it will be free to sell its shares without restriction under Rule 144 three months after it has shed its affiliate status.}

^[14]_{There is a presumption, ensconced in the legislative history of Section 1145, that a holder of more than 10% of the voting equity of the reorganized debtor will be deemed an affiliate. The staff of the SEC, however, has rejected a bright line test and stated that the determination of “affiliate” status for purposes of Section 1145 is to be made in the same manner as for all other purposes of the securities laws. When evaluating whether a 10% holder is an affiliate, practitioners will look to indicia of control, including whether there are other, more substantial holders of the issuer’s equity and whether the investor has other relationships with the issuer, such as the right to board representation, that may be indicative of influence over the management of the issuer.}

^[15]_{Rule 13d-3(d) of the Securities Exchange Act of 1934 prescribes the methodology for including rights to acquire shares in a beneficial ownership calculation. The shares issuable upon exercise of the rights held by the particular investor — but not the rights held by any other investor — are included in both the numerator and the denominator when computing the percentage ownership of the investor. Only rights exercisable within 60 days are included, but inclusion does not depend on whether the rights are “in the money.”}

^[16]_{Typically, the issuer will register the resale of shares of the creditors under a shelf registration statement, allowing the creditors to sell their shares from time to time on a delayed basis. Sales can be made either directly into the market, in underwritten offerings or in other ways, all of which are referred to as shelf takedowns. Underwritten offerings involve the time and expense of the issuer, and it is these types of shelf takedowns that the issuer will seek to limit under the terms of the registration rights agreement (as discussed below and referred to there as registered offerings).}

^[17]_{See note 15 regarding the beneficial ownership calculation.}

^[18]_{This assumes that the reorganized debtor will be registered with the SEC at the time of emergence. The requirements differ if the reorganized debtor registers after the shares have been issued.}

^[19] _{Reporting under Section 13(d) and Section 16 entails numerous other details and nuances, which cannot be addressed here.}

^[20]_{Under a Section 1145-compliant plan, while affiliated creditors obtain the benefit of the ability to sell immediately in small quantities under Rule 144, this benefit is likely to be marginal to their exit strategy. Their focus will instead be on the terms of their registration rights and their role in the corporate governance of the reorganized debtor.}