There have been some important recent legal developments that will likely impact acquisition finance. This article will survey some of the more notable ones.
The Eleventh Circuit Court of Appeals, on May 15, 2012, overturned1 a prior District Court decision stemming from the bankruptcy case of Tousa, Inc., affirming a bankruptcy court’s earlier 2009 decision that had ordered the return, on fraudulent transfer grounds, of over $400 million that had been repaid to prior lenders of the Tousa parent company in connection with a secured financing to the parent and its subsidiaries.
The bankruptcy court’s 2009 decision had startled the lending community, whose tension was relieved by the District Court’s 2011 reversal. By rejecting the District Court’s ruling, the Circuit Court has raised these concerns anew, which may significantly impact the acquisition finance market.
The case, at its core, involved the repayment of previously existing debt owed only by the Tousa parent (Old Debt) with proceeds of a debt financing to the parent and its various subsidiaries, secured by liens on their assets (New Debt). The bankruptcy court, affirmed now by the Circuit Court, held that (i) the subsidiaries did not receive “reasonably equivalent value” for the liens they granted in their assets (to secure the New Debt that rendered them insolvent), because the proceeds of the New Debt were used to pay off the Old Debt for which the subsidiaries were not liable, and the granting of liens by the subsidiaries was thus a fraudulent transfer under the Bankruptcy Code, and (ii) the holders of the Old Debt were beneficiaries of the fraudulent transfer subject to disgorgement of the repayment received. The Circuit Court, among other things, rejected the District Court’s ruling that intangible benefits such as the delay and avoidance of bankruptcy for certain affiliates constitutes “reasonably equivalent value” as a matter of law. Instead, the Circuit Court ruled that the determination of “reasonably equivalent value” for such purpose is a fact-driven one, and that the bankruptcy court had not exceeded its authority in determining that the intangible benefits to the subsidiaries in this case were insufficient, in light of the somewhat extreme facts with which the court had been presented. The Circuit Court did not rule on the bankruptcy court’s holding that the determination of insolvency is properly made for each subsidiary individually (and not on a consolidated basis), and remanded the case back to the District Court for consideration of appropriate remedies consistent with the Circuit Court decision.
Although not binding on Federal courts in the second or third circuits (which include New York and Delaware, respectively), the Eleventh Circuit’s decision is likely to be taken seriously by lenders throughout the country, due to the rank of that Court and the nature of its ruling in the case.
The decision presents important issues for lenders, especially in cases in which entities not indebted to them are involved in their repayment and in precarious financial condition. It had generally been assumed in the loan markets that repayment of a valid antecedent debt held by a non-insider is subject to disgorgement only during the applicable 90-day preference look-back period immediately prior to filing of a bankruptcy petition. After Tousa, the potential disgorgement period is seemingly extended to at least the two-year look-back period for fraudulent transfers, and possibly longer under analogous state fraudulent conveyance laws.
Among the unanswered questions the market will need to sort through in Tousa’s wake are:
- Will lenders financing an acquisition require a sponsor to make an equity investment greater than it otherwise would be required to, in order to reduce risk of a later judicial finding of insolvency of the acquired group (notwithstanding solvency assurances given at closing)?
- Will acquisition lenders require solvency certificates and other evidence of solvency on a consolidating — i.e., entity-by-entity — basis as well, rather than just on a consolidated basis, as has been market practice? If so, will compliance be feasible? Will the value of secured guarantees from subsidiaries whose solvency is questionable on a stand-alone basis be discounted by lenders in their credit analysis? If so, what will be the impact on loan pricing?
- Will lenders begin to incorporate into acquisition financing commitment and loan documentation terms relating to the eventual repayment of their loans, such as informational requirements as to the identity of and circumstances surrounding any nonobligor involved in repayment? Would lenders consider imposing new conditions to their own repayment in a stressed or distressed context? Could any such conditions be designed (e.g., perhaps as optional rights) consistent with lenders’ interests in being repaid?
- To what extent will committees of unsecured creditors in bankruptcy cases, and others seeking to unwind secured financings, be successful in attempts going forward, in different factual settings under a fraudulent transfer theory, to broaden application of the Tousa holding by using its principle of determining solvency and benefits received on an individual-entity basis?
The Delaware Supreme Court recently affirmed a Court of Chancery decision in SV Investment Partners, LLC v. ThoughtWorks, Inc.2 which had held, in the context of preferred stock that was required to be redeemed out of “funds legally available” for redemption, that “funds legally available” is narrower in scope than “surplus.” In rejecting a claim by the preferred shareholders that “funds legally available” is equivalent to “surplus” in such context, both courts held that “funds legally available” includes the concept that the funds be at hand or readily accessible, and the courts gave substantial deference to the company’s board of directors in determining whether it in fact had funds available from time to time for redemption of the preferred shares, including its determination of needed levels of ongoing cash reserves. The Court of Chancery had determined that, for the preferred shareholders to have prevailed, they would have had to demonstrate that the issuer’s board had acted in bad faith in determining the availability of funds for redemption, or would have needed to have relied on unreliable information, or “made determinations so far off the mark as to constitute actual or constructive fraud.” The decision sounds a cautionary note for investors financing an acquisition through the purchase of redeemable preferred shares.
The case arose out of the purchase in 2000 by SV Investment Partners, LLC (SVIP) of 94% of the Series A Preferred Stock of ThoughtWorks, Inc. (ThoughtWorks). The holders of the preferred shares were entitled to redeem the shares for cash beginning five years after issuance “out of funds legally available therefor.” In the event insufficient funds were available for redemption of all the preferred stock so elected to be redeemed, any funds becoming available after the initial redemption were required to be applied to continuous redemptions until the preferred shares in question were fully redeemed. When SVIP exercised its redemption right, ThoughtWorks’ board concluded that, while the company had cash, it had no legally available funds for the redemption. SVIP asserted that the company had sufficient “surplus” as defined by Section 160 of the Delaware General Corporation Law, and therefore had sufficient “funds legally available” for the redemption. The Court of Chancery, however, concluded that the two terms were not synonymous and that the latter “contemplates ‘funds’ (in the sense of cash) that are ‘available’ (in the sense of on hand or readily accessible through sales or borrowing) and can be deployed ‘legally’ for redemptions without violating Section 160 or other statutory or common law restrictions, including the requirement that the corporation be able to continue as a going concern and not be rendered insolvent by the distribution.”
The Court of Chancery makes it clear that the terms of a corporate charter, including preferred stock’s rights, duties, powers, preferences, etc., are contractual in nature and thus subject to contractual construction by courts. Additionally, a board may not authorize a redemption of preferred equity unless both (i) the corporation’s net assets exceed the redemption amount and (ii) after the redemption the corporation has the ability to continue to pay its debts as they come due. As such, in considering whether to finance acquisitions using preferred equity, investors should consider spelling out in detail what assets must be legally available to make a redemption, whether the corporation will be required to sell assets to make redemptions, and whether the board must use a specific method of valuation in determining what funds or other assets are available to make redemptions. In terms of limiting a board’s ability to establish cash reserve levels that could interfere with redemptions, investors could, for example, include in their charter provisions negotiated levels of maximum cash reserves, beyond which funds would be available for redemption.
Last fall, we discussed the Circuit Court split resulting from the Seventh Circuit’s ruling in River Road v. Amalgamated Bank.3 There, the Seventh Circuit ruled in favor of the secured creditor’s ability to credit bid in a Chapter 11 auction; this ruling was in direct contrast to rulings reached by the Third and Fifth Circuits in similar cases. In December, the U.S. Supreme Court granted certiorari under the caption RadLAX Gateway Hotel, LLC v. Amalgamated Bank, to address whether a debtor may pursue a Chapter 11 plan that proposes to sell assets free of liens without allowing the secured creditor to credit bid, but instead providing it with the “indubitable equivalent” of its claim under Section 1129(b)(2)(A) (iii) of the Bankruptcy Code.4
The Loan Syndications and Trading Association (LSTA), a loan industry trade association, filed an amicus brief in support of Amalgamated Bank in favor of granting certiorari. In its brief, the LSTA noted that “[s]ecured creditors’ ability to credit bid at auctions of their collateral is central to the detailed scheme of protections that the Bankruptcy Code provides them.” Further, it noted that the uncertainty and inconsistency between federal circuits “will impose additional risks on secured lenders, raising the cost of capital at a particularly inopportune moment for the national economy.”
The U.S. Supreme Court has now issued its ruling,5 siding with the position of the Seventh Circuit and the LSTA, and delivering a major victory to secured parties, by holding unanimously that secured creditors must be allowed to credit bid if a debtor seeks to sell assets constituting collateral under a plan of reorganization free of the liens of the secured parties.
We previously discussed potential regulation affecting banks and certain designated nonbanks consisting of more stringent capital reserve requirements for lending commitments maintained by the lending institution from time to time, under the framework of the Basel III reforms recommended in 2010 by the Basel Committee on Banking Supervision. On December 20, 2011, the U.S. Federal Reserve Board issued proposed rules that would begin implementation of enhanced liquidity requirements proposed by Basel III, including a new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).6
The proposed rules introduce liquidity stress test requirements for certain banks and require them to maintain liquid assets sufficient to meet projected net cash flows under the stress tests. The proposed rules also state that the Board will propose a second phase of regulations to implement the LCR and NSFR. The LCR would require banks to hold an amount of high-quality liquid assets sufficient to meet expected net cash outflows over a 30-day time horizon under stress scenarios. The NSFR would require banks to enhance their liquidity risk resiliency out to one full year. These new requirements could eventually increase costs of borrowing from regulated institutions, which would need to maintain liquid assets sufficient to meet projected net cash outflow obligations under lending commitments available for drawdown and related exposures. While the implementation timetable announced by the Basel Committee generally calls for implementation of the LCR and NSFR tests by 2015 and 2018, respectively, the reforms become binding on relevant institutions only through their adoption and implementation by relevant banking authorities, such as the Federal Reserve Board and European Banking Authority. The Federal Reserve Board has stated that, under the terms of Basel III, banks under its jurisdiction will be required to comply with the LCR and NSFR tests by 2015 and 2018, respectively.7
In its assessment of the long-term economic impact of the enhanced liquidity and capital proposals of the Basel Committee, the Bank for International Settlements notes,8 using various assumptions it characterizes as conservative: “First, each 1 percentage point increase in the capital ratio raises loan spreads by 13 basis points. Second, the additional cost of meeting the liquidity standard amounts to around 25 basis points in lending spreads . . . .”9 The report emphasizes the potential economic benefits of more conservatively capitalized banks and avoidance of future bank failures and related crises. If lending commitments become less attractive to banks, they could become more costly and generally more difficult to obtain, or they might be made available as a special service by banks primarily to their better customers who generate revenue for the banks from unrelated transactions. This potentially could present an additional challenge to sponsors seeking revolving financing for portfolio companies or for targets of a contemplated acquisition.