© 2011 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 13 edition of the Bloomberg Law Reports—Bankruptcy Law. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P.
In the wake of the economic downturn, the concept of debt reinstatement – colloquially referred to as "cram ups"1 – has emerged as an important one in the restructuring arena. A number of companies raised sizable amounts of debt capital on covenant-lite terms when credit markets were particularly frothy between 2005 and 2007. But, with the onset of the commercial credit crisis making it much harder for troubled companies to access the credit markets in recent years, some Chapter 11 borrowers have sought to effectuate a deleveraging of their balance sheet through the reinstatement of favorable loans. To be sure, a number of financings were made in the pre-Lehman period on financial terms that, if marked to market in today’s credit environment, would be prohibitively expensive. In view of this, creative borrowers have begun to craft restructuring strategies that revolve around retaining the economic value of below-market secured lending arrangements.
In connection with this, the United States Bankruptcy Court for the Southern District of New York issued an important ruling in late 2009 in the hotly contested and closely watched confirmation hearing in the Chapter 11 bankruptcy case of Charter Communication, Inc. (Charter), which was premised on Charter’s effort to reinstate billions of dollars of secured debt.2 In what bankruptcy judge James Peck described as "perhaps the largest and most complex prearranged bankruptcies ever attempted, and in all likelihood ranks among the most ambitious and contentious as well,"3 the bankruptcy court observed that Charter was "endeavoring with singular creativity and determination to reduce its heavy debt load and recapitalize itself during perhaps the most challenging period in the modern era of global corporate finance."4 The court went on to write: "Viewed simplistically, the litigation over [plan] confirmation amounts to an inter-creditor dispute over which class of creditors should receive enhanced returns. Viewed more theoretically, the litigation is a test of the chapter 11 process itself… Accordingly, this contest is the culmination of calculated pre-bankruptcy planning (that might even be called a gamble) designed to obtain significant restructuring benefits over the foreseeable strenuous objections of formidable adversaries."5
Prior to its bankruptcy filing in March 2009, Charter, one of the nation's largest cable television companies, engaged a team of restructuring experts, led by Lazard, to design a strategy that would eliminate substantial debt from its balance sheet while avoiding a potential free-fall bankruptcy process. After reaching agreement concerning the terms of a restructuring arrangement with certain of its junior lenders (but not its senior lenders), Charter filed for bankruptcy protection and sought confirmation of a pre-arranged Chapter 11 plan of reorganization that proposed to eliminate roughly $8 billion of debt from its highly-leveraged capital structure and reinstate nearly $12 billion in senior secured debt so as to preserve favorable interest rate terms. Funding for Charter’s plan was to be derived from approximately $3.5 billion in capital and financing from ongoing operations, an exchange of holding company notes for new senior notes, and the cash proceeds from an equity rights offering. Charter took the position that its senior secured lenders were unimpaired and were deemed to have accepted the proposed plan of reorganization because of the contemplated debt reinstatement. A bit of bankruptcy background is useful here.
The Bankruptcy Code allows a Chapter 11 debtor to put forth a plan that reinstates pre-petition secured obligations, notwithstanding acceleration provisions contained in many lending agreements. A Chapter 11 plan may provide for the cure of existing defaults and thereby render a claim unimpaired. Where a class of claims is unimpaired, it is deemed to accept the plan without the need to solicit plan votes from such class. Because the reinstated class is precluded from casting a dissenting vote and blocking confirmation of the plan, it is considered "crammed up" with respect to its reinstated claim(s).
While Charter’s senior secured creditors were "paid everything that they [were] owed under the existing facility and have even received default interest during the bankruptcy cases," they "openly admit that their goal here is to obtain an increased interest rate that reflects what would be charged for a new loan in the current market for syndicated commercial loans."6 Indeed, Charter itself estimated that marking its secured credit facility to market may have cost it an additional $500 million in annual interest costs and erased several billion dollars in enterprise value.
Not surprisingly then, Charter’s senior lenders vigorously objected to the proposed debt reinstatement plan and challenged the cram up effort by alleging the existence of various covenant defaults under Charter’s pre-petition credit agreement. One such pre-petition default related to the financial condition of certain of Charter’s holding companies. The court rejected the lenders' argument that the holding companies could not prospectively pay their debts as they came due on the grounds that: (1) the credit agreement covenants did not address the holding companies' prospective inability to pay debts; and (2) the evidence failed to conclusively demonstrate an event of default under the existing credit agreement.
Undeterred, Charter’s senior secured lenders also challenged confirmation of the Chapter 11 plan on the theory that a corporate change of control would occur on the plan’s anticipated effective date, triggering a default under the credit agreement. Specifically, the credit agreement required that Paul Allen, Charter’s chairman and controlling shareholder (and the co-founder of Microsoft), retain at least 35 percent of Charter’s voting control and that no person or group control as much or greater voting power. From the bankruptcy court’s perspective, it was this change of control argument that was perhaps the "most challenging problem" for Charter in seeking to confirm its debt reinstatement, or "cram up," plan.7 Under the pre-petition credit agreement, no change of control would follow if Allen’s economic interests were eliminated, provided that he retained a minimum voting percentage of 35 percent. Charter’s plan conveniently provided that Allen would receive nothing on account of his existing equity investment, but he would nonetheless retain the requisite 35 percent voting control over reorganized Charter. In addition, Charter agreed to pay Allen $375 million in consideration for his continued voting participation in the reorganized business enterprise. In return, the court found that Charter had received $3.5 billion in benefits, including hundreds of millions of dollars saved by reinstating its senior secured indebtedness at a below-market interest rate, coupled with $1.14 billion in tax savings associated with the preservation of net operating losses. Confirmation of Charter’s plan would not, in the court’s considered opinion, run afoul of the contractually bargained-for change of control requirements.
The court also determined that the so-called "fulcrum" noteholders, who had participated cooperatively with Charter in restructuring negotiations, did not constitute a "group" under the securities laws such that the equity stakes that they would be receiving under the reorganization plan should be aggregated; otherwise, they would own a greater percentage than Allen would hold in reorganized Charter, in contravention of the credit agreement’s change of control restrictions. Ultimately, the court determined that there was no impermissible change of control under Charter’s proposed Chapter 11 plan.
Interestingly, a similar attempt to cram up a Chapter 11 plan arose before the same bankruptcy court (albeit with a different bankruptcy judge presiding) on the heels of the Charter decision. In In re Young Broadcasting, Inc.,8 the creditors’ committee proffered a plan of reorganization for the Chapter 11 debtors that provided for reinstatement of $338 million of pre-petition secured debt. The proposed plan also provided for a distribution to noteholders of a pro rata share of 10 percent of the equity in the reorganized company (consisting of Class A shares) and afforded them an opportunity to participate in an equity rights offering for an additional 80 percent of new common stock (consisting of Class A shares), as well as $45.6 million of preferred stock.
However, the pre-petition credit agreement at issue in Young Broadcasting contained change of control restrictions that required, among other things, that: (1) the company’s principal, together with certain other individuals, retain more than 40 percent of the voting stock in the company; (2) if any person or group acquired more than 30 percent of the outstanding voting stock, the insider group had to own more than 30 percent or, alternatively, the right to elect or designate for election a majority of the board of directors; and (3) during any two year period, those individuals who were directors at the beginning of such period had to constitute the majority of directors at the end of such period. No doubt mindful of these strict limitations, the creditors’ committee’s plan provided that the board of directors of reorganized Young Broadcasting would consist of seven Class A directors and one Class B director, and that each of the 5 million Class A shares had the right to cast 20 votes for Class A directors and one vote for Class B directors, while the corporate insider, the sole Class B shareholder, had the right to cast 1,000 votes for each of his 500,000 shares for the Class B director and one vote for the Class A directors. The committee contended that this voting arrangement allowed the insider to retain 82 percent of the overall vote, which exceeded the minimum threshold under the lenders’ credit agreement.
Unlike the result in Charter, the court in Young Broadcasting sided with the secured lenders’, determining that it would be inappropriate to confirm the committee’s cram up Chapter 11 plan of reorganization. Because the primary purpose behind such provisions in the pre-petition credit agreement was to ensure that the insider group retain at least 40 percent of the actual voting power of the board of directors, the plan promulgated in Young Broadcasting would trigger a change of control event of default. The bankruptcy court acknowledged that the effort to give the insider group all of the Class B shares technically amounted to at least 40 percent of the company’s shares; however, the Class B votes did not have equal weight with the Class A share votes in terms of director elections.9 Of equal importance was the fact that the secured lenders in Young Broadcasting also objected to the corporate insider’s retention of any equity in the reorganized business enterprise, positing that such an attempt violated the Bankruptcy Code’s absolute priority rule.10 The bankruptcy court distinguished the ruling in Charter on this score, finding that the committee, as plan proponent, had failed to adequately quantify the intrinsic economic value of effectuating a debt reinstatement strategy.11 (Recall that in Charter, evidence was presented to the court demonstrating that the cram up plan would yield billions of dollars in tangible economic value to the businesses).
Although a relatively recent phenomenon, debt reinstatement has appropriately surfaced as a legitimate technique to restructure balance sheets around senior secured credit facilities by rendering them unimpaired. Without question, bankruptcy courts will continue to face resourceful efforts by borrowers possessing valuable low-interest loans to implement debt reinstatement plans of reorganization, particularly if the credit markets remain fairly restricted. Decisions like those in Charter and Young Broadcasting are "must" reading for restructuring professionals and distressed investors alike analyzing the viability of a "cram up" reorganization strategy.