Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 94 C 4601--Robert W. Gettleman, Judge.
Before POSNER, Chief Judge, and KANNE and EVANS, Circuit Judges.
Three years ago Itel Corporation, which owned all the common stock plus 78 percent of the Class B debentures of the Green Bay & Western Railroad Company, sold the railroad. The owners of the remaining Class B debentures, who are the plaintiffs in this class action against Itel, claim to be entitled to share in the proceeds of the sale over and above the $1,000 face value of each debenture that they received when, in accordance with the terms of their debenture certificates, the debentures were repaid out of the proceeds of the sale. They argue that in refusing to honor their claim Itel has converted property that is rightfully theirs, in violation of both federal and state law under a variety of legal theories unnecessary to discuss. The district judge granted Itel's motion to dismiss, ruling that the debentures did not entitle the holders to more than $1,000 per debenture. If the ruling is correct, the suit has no merit and was properly dismissed without regard to the defendant's numerous other defenses. This is so even though the plaintiffs also complain about Itel's refusal, before it sold the railroad, to credit (more precisely, to cause the railroad, which it controlled, to credit) any of the railroad's income to the Class B debentures. But this complaint, at least as the plaintiffs formulated it in the district court--and it is too late for them to recast the theory of their case on appeal--hinges on their contention that they are the residual claimants to the proceeds of the sale. They say the residuum would have been greater had Itel properly applied the income to the improvement of the railroad rather than (as the plaintiffs allege it did) siphoning that income into the pockets of Itel's shareholders. If the debenture holders had no rights in the residuum, they were not harmed by the siphoning.
A debenture, as the word is normally used in the legal and financial communities of the United States, and as it was normally used a century ago as well, when the debentures involved in this suit were first issued, is a type of bond, specifically a bond unsecured by a lien. Richard A. Brealey & Stewart C. Myers, Principles of Corporate Finance 597 (4th ed. 1991); William Z. Ripley, Railroads: Finance & Organization 142 (1915). Ordinarily, when a corporation is sold, the proceeds above what is needed to pay off creditors, including bondholders--including therefore debenture holders--go to the shareholders, as the residual claimants to the corporation's assets. The plaintiffs argue that, contrary to the norm, the Class B debentures in the Green Bay & Western Railroad Company were intended to be the equivalent of shares of stock, while the shares of stock were intended to be the equivalent of debentures. They ask us to look behind the labels that these instruments bear to the economic reality.
Each debenture certificate is a contract between the railroad and the debenture holder, and parties to a contract can agree to use words in a nonstandard sense. But it does not help the plaintiffs' case that they are unable to direct us to any other instance in U.S. corporate history in which the word "debenture" has been used to denote an equity interest. Convertible debentures, that is, debentures convertible into stock upon the coming to pass of stated conditions, have by virtue of their conversion feature an equity hue; but the debentures issued by the Green Bay & Western Railroad are not convertible. A treatise gives an example of where the term "debenture" has been interpreted to mean preferred stock. 6 Fletcher Cyclopedia of the Law of Private Corporations sec. 2649.1, p. 27 (1989 rev. ed.). But there is much less space between a conventional debenture and preferred stock than between a conventional debenture and common stock, since preferred stock normally is "maxed out" at its stated par value, 11 id. at sec. 5303, p. 592, just like the Class B debentures if Itel's interpretation is accepted.
To determine whether the interpretation is correct requires an examination of the history and terms of the securities. The Green Bay & Western Railroad was created, under a different name, in 1866. It went broke ten years later and again in 1888, emerging from the second bankruptcy exactly one century ago, in 1896, with a radically new capital structure. The first mortgagees, who had foreclosed on the railroad's property, received all the capital stock of the new company--25,000 shares with a par value of $100 each. The second mortgagees and old shareholders received the Class B debentures--7,000 debentures each with a face value, as we have said, of $1,000--and also, in exchange for investing $600,000 of new money, 600 Class A debentures with a face value of $1,000 each. None of the three classes of securities specified either maturity dates or a fixed entitlement to income, and only the capital stock had voting rights.
Although the debentures do not create a fixed entitlement to interest or dividends, they do provide for the allocation of any annual dividends that the board of directors decides to declare. The dividends are to go to the holders of the Class A debentures until those investors have received 2.5 percent of the face value of the debenture, then to the shareholders until they have received 2.5 percent of the par value of their stock, and then to the holders of the Class A debentures and the shareholders, pro rata, until the two groups have received a total of 5 percent of the face value of the Class A debentures and of the par value of the stock. Any money left after these distributions is to go to the holders of the Class B debentures. In simplest terms, then, the Class B debenture holders are entitled to any dividends that exceed what is necessary to give the shareholders and the Class A debenture holders 5 percent of the face amount of their securities.
In the event of a sale or reorganization of the company, the Class B debenture certificate specifies the following distribution of the proceeds after payment of all liens and charges: the first $600,000 to the holders of the Class A debentures, the next $2.5 million to the shareholders, and either the rest--or the first $7 million of the rest--to the holders of the Class B debentures. Which it is is the issue in this case.
Each Class B debenture certificate states that the Green Bay & Western Railroad Company
certifies that this is one of a series of seven thousand of its Class B Debentures, in the sum of ONE THOUSAND DOLLARS each, aggregating in all the sum of Seven Million Dollars, which sum of One Thousand Dollars will be payable to the bearer hereof as follows: viz., only in the event of a sale or reorganization of the Railroad and property of said Company, and then only out of any net proceeds of such sale or reorganization which may remain after payment of any liens and charges upon such railroad or property, and after payment of Six Hundred Thousand Dollars to the holders of a series of Debentures known as Class A, issued or to be issued, by said Company, and the sum of Two Million Five Hundred Thousand Dollars to and among the stockholders of said Company. Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures. [Emphasis added].
Itel argues that the first clause that we have italicized makes clear that the only entitlement of the holders of Class B debentures is to $1,000 per debenture. The plaintiffs argue that the last sentence in the quoted passage, which we have also italicized, makes clear that any proceeds from a sale over and above all liens and charges, $600,000 to the holders of the Class A debentures, and $2.5 million to the shareholders, go to the holders of the Class B debentures, making them in effect the equity owners of the railroad. On Itel's reading the shareholders have a debt-like claim to the par value of their stock (the $2.5 million) that is subordinate only to the other creditor interests (including that of the Class A debentures) but they also have the normal equity interest, which comes into play after the Class B debenture holders are paid their $7 million.
The question of what happens after the Class B debenture holders receive the full face value of their debentures cannot arise unless at the time of sale or reorganization the net value of the company exceeds $10.1 million, the sum of the face or par values of the three classes of security. That happy eventuality must have seemed remote in 1896, for the debentures and other documents of the 1896 reorganization do not make clear provision for it. Nevertheless the presumption in 1896 as now was (is) that the residual, unprovided-for value of a corporation belongs to the shareholders rather than to the holders of debentures or other bonds. The first clause that we italicized in the Class B debenture reinforces the presumption, for it states flatly that the holder's right in the event of a sale or reorganization of the railroad is to receive the face amount of the debenture, $1,000. The sentence on which the ...