PEPPERDINE UNIVERSITY SCHOOL OF LAW

FINAL EXAM:	Business Reorganization	TOTAL NO. OF QUESTIONS:	2

in Bankruptcy--

Essay Portion

SPRING 2001	TOTAL NO. OF PAGES:	4

PROFESSOR	Scarberry	TIME:	Two (2) Hours

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INSTRUCTIONS

1.	This portion of the exam consists of two essay questions and will count as two-thirds of your final examination grade. The multiple choice section will count one-third.

2.	You are permitted to use the casebook, the statutory supplement (annotated as you wish), your notes, and a calculator on this portion of the examination.

3.	Please use blue or black pen only (unless you are typing or using examsoft), and start each question in a separate bluebook.

4.	Thanks for making teaching worthwhile. (Well, this isn't an instruction, but I wanted to say it anyway.)

Essay I--1 Hour

Delite Incorporated, a manufacturer of ice cream and other frozen desserts, recently filed a chapter 11 petition. Delite is also involved in litigation over whether Delite's ice cream manufacturing process violates the patent rights of a competitor, CreamCo, which invented and patented a new way of making ice cream a few years ago. It is not at all clear whether Delite's process infringes on CreamCo's patent, but if it does, please assume that Delite and any stores selling Delite ice cream will be liable for substantial damages. A few months before Delite filed its chapter 11 petition, CreamCo sued Delite and Lavon's Markets Corp. for the alleged patent infringement. Lavon's owns and operates several retail grocery stores and is one of Delite's biggest customers. The long-term contract for sale of ice cream from Delite to Lavon's provides that Delite shall indemnify Lavon's for (1) any judgment entered against Lavon's for patent infringement relating to the ice cream "without regard to whether such judgment is correct or erroneous," and (2) for all attorneys' fees incurred by Lavon's in such litigation, whether or not a judgment is entered against Lavon's. Please assume that the contract provides the only basis for any claim by Lavon's against Delite for damages or expenses arising from the patent dispute.

CreamCo has taken no actions in the lawsuit with respect to defendant Delite since the chapter 11 filing. But CreamCo has continued to pursue its claims against Lavon's vigorously. Lavon's is also considering making a substantial investment in Delite as part of the chapter 11 process, but finds it difficult to focus on that in the midst of the patent litigation.

Delite has now come to you, the bankruptcy judge, seeking a determination that CreamCo has violated the automatic stay, or in the alternative, seeking the grant of an injunction prohibiting CreamCo from continuing to prosecute its action against Lavon's during the course of Delite's chapter 11 case. In addition, Moore Mortgage Company, holder of the only real estate mortgage on Delite's large factory property, is seeking relief from the stay to foreclose its mortgage. Delite missed several mortgage payments before filing its chapter 11 petition, and has paid Moore nothing since that time. The factory property is worth about $10 million. The amount owed to Moore on the mortgage is $9 million, and the mortgage carries a 12% interest rate (1% per month). The factory property will depreciate in value by about $80,000 per month due to wear and tear on the factory buildings—assuming general real estate values do not change. Real estate values seem to be stable, but of course that could quickly change.

Please decide the motions brought by Delite and by Moore, considering all reasonable arguments that could be made on each side. If you determine that either or both of them are not now entitled to any relief, please discuss whether at some later point in time relief might be appropriately given.

Essay II--1 Hour

It is now late 2001. DireCo, a chapter 11 debtor, is about to seek confirmation of its proposed plan. Exclusivity has been maintained during the entire case; no other party has been permitted to file a proposed plan. Claims in the case consist of (1) a $25 million debt to First Bank, secured by a first mortgage on DireCo's real property; (2) a $1 million debt to Ajax Finance Co., secured by a first lien on DireCo's fleet of 80 delivery trucks; (3) 55 general unsecured claims totalling $100 million; and (4) $5 million in administrative expenses. DireCo's real property is worth about $40 million; assume that the mortgage's interest rate is a fair market rate. DireCo's fleet of delivery trucks is worth about $1.5 million. In addition, DireCo has other personal property that it uses in its business.

The effective date of the plan will be approximately 1/1/2002. You are determining the reorganization value of DireCo's assets using a 5 year projection period (1/1/2002 to 12/31/2006). Thus far you have determined that the present value of the cash flows as of 1/1/2002 for the first four years of the projection period totals $20 million. DireCo projects the following results for 2006, the fifth year (all numbers in millions of dollars):

Sales	100

Cost of goods sold	75

Gross profit	25

Selling & admin.

expenses	18

Net income before

taxes	7

Taxes	2

Net income after

taxes	5

The projected cost of goods sold for the fifth year includes $4 million in depreciation and amortization. Projected selling and admin. expenses for that fifth year include $1 million in depreciation and amortization. DireCo expects to have to invest 3 million during fifth year in capital expenditures and increased working capital. DireCo's cost of capital is 14%. Investigation shows that three companies similar to DireCo (except that they are not in financial distress) are valued by the market at multiples of 4.5, 5, and 5.5 of EBITDA, respectively. DireCo has surplus assets—assets not needed for operation of the business—which can be sold quickly for $400,000. In a liquidation as of 1/1/2002, general unsecured creditors would receive payment of about 20% of the amount of their claims.

The proposed plan sets up four classes: Class 1 (consisting of First Bank's secured claim), Class 2 (consisting of Ajax's secured claim), Class 3 (consisting of all the general unsecured claims), and Class (4) (consisting of the interests of DireCo's sole shareholder, Sal, who is the only insider in this fact pattern). With one exception, DireCo has accumulated enough cash to pay the administrative expenses in full in cash on the effective date (as the plan provides) and to make the other payments the plan requires to be made on the effective date. The exception is a $2 million claim owed to Sal, for money she lent to DireCo during the chapter 11 case. As ordered by the court, that $2 million is an administrative expense claim. See below for treatment of that claim in DireCo's proposed plan.

The plan provides that First Bank's secured claim will not be affected in any way (and thus that Class 1 is unimpaired). Ajax will receive payment of its Class 2 $1 million secured claim in 60 equal monthly installments, with the monthly payment sufficient to pay off the $1 million plus a market rate of interest over the 60 months. (Be advised that Ajax's original agreement would have required that the debt be paid off completely by the end of 2003.) The plan provides that for each $1000 of claim, the holders of claims in Class 3 will receive $50 cash, a promissory note for $150 at a fair market interest rate, and one share of stock in the reorganized DireCo. The plan provides that Sal's shares of stock in DireCo will be cancelled and that she will receive nothing on account of his old stock. However, the plan calls for Sal to receive 200,000 shares of stock in the reorganized DireCo as payment in full for the $2 million administrative expense owed to her.

Ajax voted its claim in favor of the plan. Holders of 40 of the general unsecured claims, totalling $80 million in amount, voted their claims; holders of the other 15 general unsecured claims did not bother to vote. Of the 40 Class 3 claims voted, 22, totalling $50 million in amount, were voted in favor of the plan; 18 of them, totalling $30 million, were voted against the plan.

Please discuss the following questions:

(1) What is the total reorganization value of DireCo's assets as of the proposed effective date under the discounted cash flow method? In performing the discounted cash flow valuation, use the perpetuity method for determining the residual value. Then calculate the residual value again using the multiple of EBITDA method, and compare your results.

(2) What will the value of each share of stock be in the reorganized DireCo?

(3) Did Class 3 accept the plan?

(4) Does the plan treat Class 3 fairly and equitably? Does that matter?

(5) If a holder of a Class 3 claim objects to the plan on the ground that it does not meet the "best interest of creditors" test, will the court sustain or overrule that specific objection?

(6) Is section 1129(a)(10) satisfied? For purposes of this part (6), assume Class 3 did not accept the plan.