Recent legal and regulatory developments have raised issues for those considering a loan-to-own acquisition strategy, and have continued to impact both the structure of highly leveraged financings and the makeup of those willing to provide it.
In re RML -- Irrational Exuberance?
In our last newsletter we discussed two bankruptcy court cases1 decided in 2014 standing generally for the proposition that the right to credit bid may be limited “for cause” in order to foster a more robust and competitive bidding environment, at least where the secured creditor that desired to credit-bid attempted to expedite the credit-bid sale process unreasonably, or was otherwise deemed to have acted inequitably in terms of opposing a robust and competitive auction for the collateral in question. Because the secured creditor’s conduct that was viewed by the court as improper in those cases consisted of activities not uncommon for secured creditors in similar contexts (such as doing everything practicable to expedite its acquisition of the assets in question), one could view those courts as flirting with the notion that a secured creditor’s ability to credit bid the full face amount of its outstanding debt for its collateral, in itself, confers an unfair advantage over cash bidders, sufficient in certain cases to fatally chill a competitive bidding process. That in turn could justify the limits placed by these courts on the credit-bid rights in question, imposed in order to foster a more competitive bidding environment, perhaps on the implicit reasoning that a would-be credit bidder, if a distressed-debt investor, should fairly have its ability to credit bid limited to what it had paid for the debt it holds. Though certainly not explicit, this seems to have been the direction and rationale of the decisions. The holdings of those cases, in embracing an expansive approach toward defining “cause” for this purpose, would support challenges to any secured creditor’s ability to credit-bid the full face amount of its debt in a bankruptcy auction.
Following those two decisions, the U.S. Bankruptcy Court for the Western District of Tennessee issued a decision that some have viewed as reversing the trend of those two cases. On closer examination, however, this seems not to be clearly so.
In In re RML Development, Inc.,2 a secured creditor with senior liens on two residential apartment complexes, which secured obligations in the approximate amount of $2.5 million, filed a motion to enable it to credit bid the full amount of its secured claim in the bankruptcy auction for the complexes. No inequitable conduct on the secured creditor’s part relating to the auction process was alleged, as had been the case in the two decisions described above. The debtor admitted approximately $2.3 million of the secured creditor’s claim and raised objections, characterized by the court as “bona fide,” contesting the remaining approximately $200,000 balance of the secured claim. The court granted the secured party’s motion to credit bid, up to the uncontested portion of its secured claim. The court stated, “the bankruptcy court should only modify or deny a . . . credit bid when equitable concerns give it cause. This court believes such a modification or denial of credit bid rights should be the extraordinary exception and not the norm.”3 This statement by the RML court seems to indicate that the holding in RML opposes the holdings of the two earlier cases. Yet, on closer examination this seems not quite the case.
First , as noted above, in RML the secured creditor was not alleged to have attempted to expedite the collateral sale process unreasonably or otherwise to have acted inequitably in terms of trying to dampen the competitiveness of the auction for its collateral. Thus, the court’s statement that credit bid rights should be modified or denied only in extraordinary cases does not constitute a holding by the court, under the facts of the case, that credit bid rights will not be limited where such conduct by the secured creditor is indeed at issue. It is mere “dictum” for such a proposition when appearing in a case such as RML where no such misconduct by the secured creditor in respect of the auction process was at issue.
Second, and more poignant, is the fact that the court in RML, despite its statement that only an “extraordinary exception” would warrant a modification of credit bid rights, did in fact modify the secured creditor’s credit bid rights, by limiting it to the uncontested portion of the secured creditor’s claim and by using an apparently low bar to establish that a portion of the secured claim was contested. The standard utilized in this case for such purpose seems to have been the existence of a “bona fide” dispute. That seems to exclude only frivolous disputes, and not to require any establishment of a prima facie case or presentation of evidence as to the merits of the position taken, which the court appeared not to require. This seems to set a low bar on which to base the court’s modification of the credit-bid right, especially given the court’s announced standard that only an "extraordinary exception” would warrant such a modification.
Still, the RML court was of the view that a creditor should be permitted to credit-bid at a bankruptcy sale to the extent of the uncontested claim it holds, “regardless of its intrinsic impact on other bidding.”4 This point, to be sure, is in sharp contrast to the earlier courts’ flirtation with the notion that the chilling of the bidding process caused by credit bidding itself may be sufficient cause to limit credit bidding rights, and also in contrast to the earlier court’s seeming distaste for the secured creditor’s “loan-to-own” strategy in Free Lance-Star. That court had stated that the prospect of the secured creditor’s credit-bidding up to the full face amount of its debt “depressed enthusiasm for the bankruptcy sale in the marketplace,” even suggesting that the credit bidding right was never meant to protect creditors employing a “loan-to-own” strategy, and implying that such a strategy may be viewed as inequitable in the context of a bankruptcy sale, where the creditor’s “motivation to own the Debtor’s business rather than to have the Loan repaid has interfered with the sales process.”5
Thus the RML decision, although backing away in some respects from the earlier two controversial 2014 decisions on credit bidding, does not go as far as its broad dictum would indicate. It set a seemingly low bar for limiting the credit-bid rights at issue in the case, even in the absence of any alleged interference by the secured creditor in the auction process for the collateral involved.
Leveraged Lending Guidance FAQs
As participants in the acquisition finance market make efforts to adapt to the evolving implementation standards under the Leveraged Lending Guidance, the FAQs6 recently published by the three Federal regulators (Federal Reserve Board, FDIC and OCC) seem to raise new questions regarding the Guidance even as they answer others, and appear also to raise new issues with respect to certain directions already taken by some in the market attempting to mitigate regulatory concerns stemming from the Guidance.
As an example, a number of acquisition financings arranged by traditional, regulated arrangers for their private equity firm clients have utilized a bifurcated financing structure, in which a portion of the financing is positioned at a holding company, whose debt is structurally junior to the balance of the financing that sits at the operating entity level housing the target assets. A primary objective of moving a portion of the acquisition debt from the operating companies to a holding company would be to reduce leverage ratios at the operating company level, where the entire lending commitment of the regulated arranger would reside. This would be designed to facilitate the arranger’s compliance with the Guidance, in cases in which the combined debt would translate into total leverage levels raising flags under the Guidance.
The regulators’ FAQs raise an issue for regulated entities in respect of such an approach. FAQ no. 12, dealing with multiple debt tranches and clarifying that each tranche needs to pass muster under the Guidance at origination, also speaks of the “sustainability” of the “borrower’s total capital structure.” This may imply a critical view of a regulated financier’s role in placing an entity’s entire capital structure in an unsustainable position, which if read broadly could include structurally subordinated debt at a holding company within the mix to be considered as part of the larger capital structure resulting from an acquisition arranged and structured by the regulated entity. This may be so even if the holding company debt is structured in the form of bonds rather than loans. A looming or actual default under the holding company debt, despite its structural subordination and irrespective of its form, could bring pressure to bear on the operating entities in a number of ways, potentially precipitating a larger reorganization of the corporate group due to the overall debt load, a result the Guidance seems keen on avoiding if possible.
As we mentioned in our last newsletter, another mechanism seems to have been employed in a number of cases to address concerns in the Guidance over excessive leverage levels. In an effort to achieve technical compliance with the letter, if not the spirit, of the Guidance, some deals have featured unconventionally liberal add-backs to EBITDA calculations in loan agreements in order to bring down nominal leverage multiples, in instances where more customary definitions may have resulted in significantly higher multiples subject to criticism under the Guidance. The Guidance previously had not addressed EBITDA parameters and thus had left open such potential avenues. The final sentence in the regulators’ answer to FAQ no. 3, however, addresses the issue: “Examiners will criticize situations in which EBITDA is defined in loan documents in ways that allow enhancements to EBITDA without reasonable support.” This seems squarely to reject work-arounds for regulated entities for borrower leverage multiples calculated based upon EBITDA that includes unreasonably supported add-backs. It also leaves unanswered what sort of “reasonable support” the regulators might require to justify the relevant add-backs (even those which the market had previously accepted absent any such support).
Another FAQ answer that seems to raise as many questions as it answers is the regulators’ answer to FAQ no. 6, which states that “origination” of a loan under the Guidance includes, among other things, not only the refinancing of an existing loan but also any modification of an existing loan, which includes any “change” to an existing loan. One would suspect that this is overly broad and will be clarified by subsequent rule-making. After all, if a technical amendment to a loan agreement that does not affect any of the main economic terms triggers all of the Guidance’s requirements for newly originated loans, then why not simply subject all held loans to the Guidance’s origination standards?
In time it is likely that these and other uncertainties around interpretation and implementation of the Guidance will be clarified, removing much of the uncertainty now facing regulated institutions and other participants in the leveraged finance market. In the meantime, it may be expected that unregulated entities will continue to increasingly fill the void, as regulated entities work their way through the new and evolving landscape and attempt to achieve a comfort level in respect of their roles and activities in the changing environment.