Recent Developments in Acquisition Finance
When a portfolio company underperforms, an equity sponsor will want to assess the degree of negotiating leverage the company’s lenders have against the company under the circumstances, which can play a significant role in defining the terms of waivers or amendments or of an eventual workout to be sought with the lenders. Strategic options available to a sponsor will depend, among other things, on the degree of leverage, or perceived leverage, held by lenders. Two recent court decisions may impact this balance and the relative strength of lenders versus their distressed borrowers.
In re Hercules Offshore: Defaults Too Weak for Hercules?
In In re Hercules Offshore, Inc.,1 (Hercules), the U.S. Bankruptcy Court for the District of Delaware rejected various objections raised by an equityholders committee to confirmation of the debtors’ prepackaged chapter 11 plan. The court dismissed the contention that the lenders had “conjured up immaterial defaults, catching the (sufficiently unwary) Debtor completely off guard to impose their will on the Debtor, undermine its recently confirmed plan and raid the [c]ompany’s coffers to force an expedited repayment (and a premature liquidation).”2 The court ruled that the asserted defaults were indeed sufficient under the circumstances to permit the exercise by the lenders of all available remedies under the applicable loan documentation.
Hercules Offshore, Inc., an offshore drilling company serving the oil industry, had commenced a previous chapter 11 case in 2015, from which it emerged with exit financing in the form of a senior secured credit facility, consisting of US$450 million in term loans. The exit financing included a 3% make-whole premium that would be triggered on the occurrence of certain events of default and also included a requirement that the company place US$200 million of the exit financing proceeds into escrow, to be used in certain circumstances to pay down the term loans. The escrowed funds otherwise were earmarked for the construction and purchase by the company of rights in respect of a promising project with which it was involved relating to a vessel called the Highlander. The company anticipated that the Highlander, once deployed, would prove a great boon to its earnings.
The exit financing loan documentation included certain post-closing covenants, including (i) delivery by the company to the lenders within 60 business days after closing of a certificate of registration for a certain vessel mortgage with the Nigerian Maritime Administration and Safety Agency (Vessel Registration Covenant), and (ii) its using its “best efforts” to dissolve one of its Gibraltar subsidiaries within 120 days after closing (Dissolution Covenant).
Following the company’s emergence from its first bankruptcy case, rapidly declining oil prices caused its financial condition to deteriorate once again. The company responded by forming a special committee of its board of directors and hiring a financial advisor to explore strategic options, including a potential sale of certain of its assets or of the entire company, and began a marketing process.
Meanwhile, the company needed several extensions with respect to the deadline under its Vessel Registration Covenant, to which its secured lender group acquiesced. However, a final extension request was denied by the lender group. The company wound up delivering the registration in question six days past the deadline.
The company also determined not to dissolve the Gibraltar subsidiary that was the subject of its best-efforts Dissolution Covenant, in order to avoid jeopardizing its ability to collect on an outstanding US$11 million receivable owing to that subsidiary. The company did not inform the secured lender group of this decision, and did not request an extension of the related deadline, which passed without the receivable having been collected.
The secured lenders asserted that the missed delivery deadline under the Vessel Registration Covenant constituted an event of default under the loan agreement, and that the decision not to dissolve the Gibraltar subsidiary constituted an additional event of default of the company’s covenant to use its best efforts to effect the dissolution of the subsidiary under the Dissolution Covenant.
In order to avoid the exercise of remedies by the secured lender group on account of these asserted events of default, the company entered into a series of forbearance agreements with the lenders. The terms of the forbearance included further restrictions on the company’s use of its escrowed funds, which would be applied mandatorily to pay down the term loans upon termination of the forbearance under the terms of the forbearance agreement.
During the forbearance period, the company was in dire need of liquidity and decided to sell its rights to the Highlander project to its project partners, given that the terms of the forbearance prohibited using the escrowed funds to acquire the project. The secured lender group, pointing to provisions of the forbearance and loan documentation prohibiting the company’s sale of such rights and related actions, declared that the forbearance period had terminated and elected to accelerate their term loans and apply the escrowed funds to repayment of their debt.
The company and the secured lender group subsequently entered into a restructuring support agreement providing for an orderly wind-down of the company and the sale of its assets through a liquidating prepackaged chapter 11 case. The related plan of reorganization would pay in full the relatively small amount of unsecured claims, and provide a payout of at least US$12.5 million to equityholders. The secured lenders would receive a healthy recovery, anywhere from roughly US$390 million (about 80% of their claim) on the low end, to potentially a full recovery, depending on amounts realized from the assets sales. The plan also provided for full releases of the secured lender group.
The plan was rejected by holders of the company’s common stock, who asserted that the releases provided under the plan to the secured lender group were improper, because the lenders had acted wrongfully and had breached the implied duty of good faith and fair dealing under New York law. They claimed that the lenders had improperly concocted immaterial defaults in order to coerce the company into punitive forbearance arrangements which prevented it from accessing needed funds, ultimately leading to the decline and insolvency of the business. They also argued that the lenders had breached their duty of good faith and fair dealing by having refused to agree to extend deadlines for compliance by the company with the Vessel Registration Covenant and the Dissolution Covenant. The equityholders also asserted that the lenders’ claims should either be subordinated to their interests or disallowed altogether, due to the lenders’ improper conduct.
The Hercules Court’s Analysis
The court summarily rejected the equityholders’ assertion that the lenders’ claims should be subordinated to their interests, because the U.S. Bankruptcy Code “does not permit creditors’ claims to be equitably subordinated to equity interests.”3 The court also summarily rejected their argument that the lenders’ claims should be disallowed altogether, because such equitable disallowance is “not typically recognized by bankruptcy courts.”4
The court went on to address the claims that it believed “lie at the heart of the Equity Committee’s discontent” -- the assertion that the first lien lenders breached the implied covenant of good faith and fair dealing by “(i) asserting ‘baseless’ events of default, (ii) declining to extend the deadline for the [Vessel Registration Covenant], and (iii) forcing entry into the [Forbearance Agreements].”5
The court noted that, under New York law, the implied covenant of good faith and fair dealing prohibits a party from acting “in a manner that would deprive the other party of the right to receive the benefits of their agreement,” but noted that “no obligation may be implied that would be inconsistent with other terms of the contractual relationship.”6 On that basis, the court found that the lenders had not breached their implied covenant of good faith and fair dealing, because to hold otherwise would require contradicting “explicit and unambiguous terms” of the loan documentation.
The court rejected the equityholders’ contention that the events of default in question were immaterial, and that, for example, in respect of the default under the Vessel Registration Covenant, the obligations were met only six days after the deadline had passed. Because the relevant loan agreement provisions did not contain a materiality requirement, the court held that none existed, and would not read one into the contract. The court also did not point to any course of dealing that might otherwise be argued to have bound the lenders, on account of their agreements to extend the registration deadline on prior occasions as the company had requested. The court also did not conclude, or even suggest, that the company’s delivery of the registration several days past the deadline had effectively cured the company default in question, as it might have done if it had been seeking a way to find that the lenders had acted wrongfully under the circumstances.
The court then addressed the equityholders’ argument that the lenders’ refusal to continue granting extensions under the Vessel Registration Covenant demonstrated bad faith. On this issue the court held that, because there was no requirement under the loan documentation that the lenders provide such consent, their refusal “was arguably unfortunate, but not inappropriate.”7
In response to the equityholders’ arguments that the lenders’ assertions of default were “a pretext to force the Debtors to enter into the Forbearance Agreement, thereby preventing the company from accessing the Escrowed Funds to purchase the Hercules Highlander” and that the lenders’ aggressive positions vis-a-vis the company ventured into “forbidden territory,” the court stated that lenders have a right to protect their own interests, even aggressively: “While the Court acknowledges that the First Lien Lenders were strategic in their actions, lenders are free to enforce contract rights and negotiate hard against borrowers at arms-length, particularly those that are in distress, as here. And bargain hard they did.” 8
Impact of the Decision
At first glance, the Hercules decision may seem like a huge win for lenders in settings involving potential defaults and remedies exercise, allowing them to exploit to their advantage even de minimis breaches by a borrower under the terms of governing loan documentation. But when the decision is considered in light of its context, this conclusion may be tempered a bit.
The Hercules case involved a secured lender group in a liquidating chapter 11 case following shortly on the heels of an earlier chapter 11 case. The lenders had agreed to a plan of reorganization that would pay unsecured creditors in full and give significant value to equityholders. The secured lenders were attempting to recover what they were owed, and not seeking to acquire ownership or control of the debtors. They wanted the ability to walk away with their negotiated recovery in hand, without fear of being sued the next day by the equityholders, and so had negotiated that releases be included in the proposed plan of reorganization.
This was not a case of secured lenders of a company otherwise humming along inventing events of default to extract waiver fees or the like. It was not a case of secured lenders trying to wrest control of a debtor from its equityholders through the purchase of distressed secured debt at a discount and then credit-bidding the debt in a “loan-to-own” strategy. Nor was it a case in which the secured lender group insisted on its absolute priority to the collateral value for which it had negotiated. As the court noted: “Paramount to this decision, is the evidence that the First Lien Lenders have provided substantial consideration to Hercules in exchange for the releases. . . . Given the significant monetary and process-oriented value provided to the Estates by the First Lien Lenders under the RSA and the Plan, the lender releases are reasonable and appropriate.”9
The court noted as well that, “Hercules characterized the First Lien Lenders, sardonically, as ‘aggressive,’ ‘vocal,’ ‘persistent,’ and at times ‘annoying’; however, there is no evidence that they acted unlawfully and no evidence that the Debtors were damaged by any alleged lender misconduct.”10 Yet, the decision may have been very different if the context had been a markedly different one, featuring a healthier borrower and/or a creditor making an aggressive play for control.
What this Means for Sponsors
The court’s analysis does bring home the point that courts applying New York law cannot be relied upon automatically to read a materiality requirement into every loan agreement covenant. Negotiation of loan documentation should therefore be conducted accordingly.
Marblegate -- Holdouts’ Paradise Lost
In the Fall 2015 edition of this newsletter, we discussed the potential implications of a decision in Marblegate Asset Management, LLC v. Education Management Corporation,11 in which the U.S. District Court for the Southern District of New York held that an out-of-court debt restructuring transaction violated the U.S. Trust Indenture Act12 (TIA) when it impaired a non-consenting bondholder’s practical ability to receive payment on its bonds -- even in the absence of any actual amendment of the payment terms of the related indenture or notes.
As a result of the District Court’s decision, minority bondholders could have found themselves with newfound negotiating leverage, potentially enabling them to block certain out-of-court restructurings done without their consent, at least where their “practical ability” to receive payment on their notes could be deemed impaired as a result of the transaction in question. The decision had also raised questions as to its potential applicability beyond the context of indentures qualified under the TIA, since the decision might extend as well to other indentures and instruments containing language tracking the language in the TIA that was at issue in the decision, which language indeed appears often in non-TIA indentures and similar instruments.
But the District Court decision has now been reversed on appeal by the U.S. Court of Appeals for the Second Circuit,13 which took a narrower view of the relevant TIA provision, thus depriving minority bondholders in such situations of any newfound leverage they may have thought they had by virtue of the District Court’s decision.
Education Management Corporation (EDMC), an operator of for-profit colleges, had sought to restructure debt issued under an unsecured indenture by one of its subsidiaries by forcing the bondholders to choose, pursuant to an exchange offer, between either (i) a partial recovery for all bondholders through receipt of an equity interest in EDMC (which was also a guarantor of the bonds) if all bondholders would consent to the proposed exchange, or (ii) no recovery for non-consenting bondholders and a partial recovery for consenting bondholders, if one or more bondholders failed to consent to the proposed exchange. The no-recovery outcome for non-consenting bondholders would be achieved by a series of transactions requiring no amendment to the indenture’s payment terms, but which would result in the elimination of EDMC’s guaranty of the bonds, with the bondholders thereby retaining a claim only against a shell entity with no assets.
Marblegate,14 the only bondholder that did not consent to the coercive exchange offer, filed a motion in the U.S. District Court for the Southern District of New York, seeking a preliminary injunction of the reorganization transactions contemplated by the exchange offer, on the basis that the reorganization transactions violated the TIA.
The District Court Decision
The District Court analyzed Section 316(b) of the TIA, which states that a bondholder’s right to receive principal and interest payments under an indenture or to institute suit for the enforcement of any such payment shall not be “impaired or affected” without the bondholder’s consent.
The court summed up the situation concisely: “In effect, Marblegate bought a US$14 million bond that the majority now attempts to turn into US$5 million of stock, with consent procured only by threat of total deprivation, without resort to the reorganization machinery provided by law.”15 The “reorganization machinery” of a federal bankruptcy case was not a feasible option for EDMC, because much of its funding came from federal grants which would no longer be available after a bankruptcy filing.
The District Court considered the legislative history of the relevant TIA provisions and took an expansive approach as to the rights they guaranteed to bondholders, finding that Congress intended that, under Section 316(b) of the TIA, bondholders would be protected against more than just nonconsensual modifications of their indenture’s payment provisions and of their right to sue for payment. The court held, instead, that such section of the TIA was intended to “inhibit involuntary debt restructurings outside the formal mechanisms of bankruptcy,” and that it “protects bondholders against being forced to accept a lesser payment than they bargained for, absent a restructuring in bankruptcy.”16
The District Court held that, despite the terms of the indenture that as a technical matter permitted each of the various actions taken pursuant to the exchange offer, the exchange offer as structured violated the TIA because the exchange offer and the related reorganization transactions effectively would leave non-consenting bondholders with no ability to receive payment on their bonds. The District Court declined to allow EDMC’s parent guaranty of the bonds to be released, ordering that EDMC continue to guarantee “any past and future payments of principal and interest to Marblegate on their respective due dates under the Indenture.”17 The decision was then appealed to the U.S. Court of Appeals for the Second Circuit.
The Court of Appeals’ Decision
The Circuit Court began its analysis by noting that, “because EDMC was able to reduce its debt burden through the very transaction to which Marblegate objected,” the District Court’s decision resulted in “Marblegate, as the owner of Notes that had been poised to receive only limited additional payments because of EDMC's pending insolvency, [becoming] the only creditor receiving full payouts according to the original face value of its Notes.”18 Through the exchange offer and related restructuring transactions, EDMC had in fact successfully restructured nearly all of its other debt.
The appeals court then reexamined the lower court’s entire analysis. Beginning with the text of Section 316(b) of the TIA, the Circuit Court agreed with the District Court’s conclusion that the language and structure of the statute was ambiguous, and insufficient on its own to resolve the question. The “right to receive payment” could, in its plain meaning, refer only to the “legally enforceable obligation to pay that is contained in the Indenture,” yet might also be understood as referring to the practical ability of a creditor to collect on its debt.19
The court then undertook an extensive analysis of the TIA’s legislative history, concluding finally that Section 316(b) of the TIA prohibits only “non-consensual amendments to an indenture's core payment terms.”20 In enacting the TIA, the Circuit Court held, Congress intended Section 316(b) to protect “merely a right to sue for payment under fixed indenture terms,”21 but “did not intend to go further by banning other well-known forms of reorganization like foreclosures.”22
Because the exchange offer and the related reorganization transactions did not involve any amendment of the payment terms of the underlying indenture, and because Marblegate was not deprived of its right to sue for collection of payments on its notes, the Circuit Court reversed the District Court decision, and held that the exchange offer and related transactions did not violate Section 316(b) of the TIA, thus allowing the terms of the exchange offer, including elimination of the EDMC guarantee, to stand.
What this means for Sponsors
The Circuit Court decision has eliminated (at least for now) the added measure of uncertainty that had accompanied some out-of-court restructurings involving TIA-qualified indentures during the period following the earlier, lower court ruling. The uncertainty had stemmed from the added leverage certain bondholders felt they could bring to bear as potential holdouts in the context of a transaction not involving formal amendments of bond payment terms but otherwise having the practical effect of reducing bondholder recoveries. The Circuit Court’s decision should have similar implications for out-of-court restructurings involving debt instruments that are not TIA-qualified but nevertheless contain provisions mirroring those of Section 316(b) of the TIA, whose minority bondholders might have felt similarly emboldened to play the role of holdout by the added leverage they perceived as flowing from the earlier decision of the lower court that had so broadly interpreted the language in question.
We look forward to updating you on additional developments in the next issue.